Terry Savage on Building Wealth

Here’s a financial dilemma for the successful. Anyone with money in a retirement plan faces a big decision: to convert or not to convert to a Roth IRA.

The big headline is this: There is no income limit to do a conversion from a traditional retirement plan to a Roth IRA, where all the money will grow and be withdrawn tax-free, and where there are no required withdrawals.

If you have money in an individual retirement arrangement (IRA), an IRA rollover account or a previous employer’s 40l(k), you’ll have the opportunity to convert it into a Roth IRA, where all the money can be withdrawn tax-free.

Almost every financial planning firm or mutual fund company is ready to offer advice, and online calculators guide you through the decision-making process. One of the best is at RothRetirement.com, where you’ll find step-by-step conversion information and an easy tax calculator.

There’s one important catch to conversion: You have to pay income taxes now on the amount you convert to the Roth.

And, although you should discuss this decision with your tax advisor, here are some more key points to keep in mind:

Before crunching the tax numbers, you need to understand the big issues involved in this decision. The real question is whether you think the government will keep its promise of tax-free Roth withdrawals in the future. Tax laws have been changed before in the name of “fairness.” So are you willing to trade paying taxes today out of your after-tax money for promises of future tax-free withdrawals?

Know when to pay the taxes. If you did the conversion from a traditional IRA to a Roth IRA in 2010, you have a choice of recognizing all that income in the same year (2010) or splitting equally between the next two tax years (2011 and 2012). Either way, it’s going to be a big tax bite. Remember, your traditional IRA or IRA rollover accounts are filled with pretax contributions along with untaxed gains over the years. When you do the conversion, you’ll add all that previously untaxed “income” to your current income to determine your tax liability.

Don’t plan to use money from the IRA to pay the taxes. If you do, you’ll lose the main reason for doing the conversion: the future tax-free growth of all that IRA money. Also, if you’re under age 59 ½ and take IRA money to pay the taxes, you’ll face a 10 percent penalty.

The group that might benefit most from this conversion opportunity are younger savers, who have more time for the money to compound and overcome the taxes paid now. However, even if you’re closer to retirement, there is an additional benefit: There are no required minimum withdrawals from a Roth (at age 70 ½). So, if you don’t spend the money in your lifetime, your heirs can allow it to grow tax-free, or withdraw it tax-free over their lifetimes.

Yes, this is a complicated decision. That’s why it’s important to discuss this with your tax advisor well in advance. And if you can’t come down on one side or the other, you can always convert a portion of your IRA to a Roth. That way you’ll never have complete regrets about your decision. And that’s the Savage Truth.

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