Roth IRA conversion has been a major buzz phrase this year. That’s because starting in 2010, the usual $100,000 income limitation for converting all or part of your traditional IRA to a Roth IRA goes away. With no income limitation on this type of conversion, everyone is talking about who should or shouldn’t convert and why.

We wanted to spend a couple of weeks going over these questions. First, we want to talk about what a Roth IRA is and why it’s worth using at all.

The Value of a Roth IRA

Roth IRAs are retirement accounts that have a couple of major differences from a traditional IRA. Those differences are tax-free growth and withdrawals (for qualified distributions) and no required minimum distributions (RMD) at age 70½.

Retirements plans such as 401(K)s and 403(B)s are funded with pre-tax dollars and traditional IRAs have tax-deductible contributions. Since taxes have not been paid on these dollars, distributions from these retirement accounts are taxed as ordinary income. However, Roth IRAs are funded with after-tax dollars, so you do not pay income tax on qualifying distributions because you have already paid tax on those funds. Because of this, you will never pay tax for withdrawing your original contribution dollars regardless of the situation. However, if you withdraw money from the account that isn’t part of the original contributions (such as gains) in a non-qualifying distribution, the dollars may be subject to tax and penalty, so be sure to understand the rules on Roth IRA distributions before you pull any money out.

Some examples of qualifying distributions are distributions for a first home purchase, the account owner becoming disabled, or the death of the account owner (beneficiaries can pull dollars out tax-free).

Another major difference is that you don’t have to take an RMD at the age of 70½ out of a Roth as you would a traditional IRA. Traditional IRAs start RMD at 70½ and must be taken every year regardless of need. This can have a major impact on the future of your account balance, especially in down markets. If you are forced to take distributions out of your IRA in a down market, your account balance will erode much more quickly than in an up market. With Roth IRAs, you can choose to withdraw money if you need to, but you aren’t required to.

If at your death, your spouse inherits the Roth IRA, no RMD needs to be taken. However, when your kids inherit the Roth, RMDs will be required, but the distributions will remain tax free for them, as opposed to them inheriting a traditional IRA where they will have to pay income tax on the withdrawals.

Drawbacks

There are drawbacks to a Roth IRA as well. You need to have earned income in order to contribute (for married couples only one spouse needs to have earned income for both to contribute). Also, there are income limitations on contributions (for 2010, Modified Adjusted Gross Income begins contributions phase out at $166,000 and the limit is $176,000 for married filing jointly, and contributions phase out begins a $105,000 and the limits is $120,000 for single). This rule obviously hampers high income earners from taking advantage of a Roth IRA (though, as with many tax laws, there is a loophole using conversion which we won’t get into).

All told, the Roth IRA is an excellent investment tool for saving for retirement. It’s also a great estate planning tool, allowing for you to pass tax free inheritance to your heirs. However, as good as the Roth IRA is as an investment choice, it’s not right for everyone and converting from a traditional IRA to a Roth IRA also may not be the right choice for everyone. Next week we’ll discuss the question of who should and shouldn’t convert.

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