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Mistakes to avoid when converting to a Roth IRA

BOSTON — As years go, 2010 is on course to be a blockbuster for retirement account owners. As of January, all Americans who own a traditional IRA — not just those who have modified adjusted gross incomes under $100,000 — are able to convert their accounts to a Roth IRA. • A Roth IRA is, in a way, the opposite of a traditional IRA. The Roth is funded with after-tax dollars; a traditional IRA with pretax dollars. Distributions from a Roth IRA are tax-free, while distributions from a traditional IRA are taxed at ordinary income tax rates. The original owner of a Roth IRA account is not required to take minimum distributions; the original owner of traditional IRA is required to start distributions after age 701/2. • Despite the obvious appeal of Roth IRAs, traditional IRA owners outnumber Roth owners by nearly two to one. In 2005, 37.5 million U.S. households owned traditional IRAs, while 18.6 million owned Roths, according to the Investment Company Institute. • Besides the removal of the income maximum for Roth conversions in 2010, the income tax due on conversions in 2010 can be spread over two years, with half paid in 2011 and half paid in 2012. So if you're ready to take the plunge into Roth IRAs, here are some mistakes you should avoid:

NEGLECTING TO DO THE CONVERSION: "Why would you not want to pay taxes today at known — probably very low rates — to get tax-free income at a later date (probably at higher and maybe much higher rates)?" asks Beverly DeVeny, an IRA technical consultant with Ed Slott and Co. LLC. "You don't have to convert the entire IRA all at once, but you should convert at least some of it."

FAILING TO UNDERSTAND TAX CONSEQUENCES: Doing a conversion without a thorough understanding of how it will affect your taxes is an even bigger mistake than not doing one at all, said Barry Picker, who recently served as the technical editor of 100+ Roth IRA Examples and Flowcharts by Robert Keebler.

"I've had people tell me that since they're in the 15 percent bracket, they can convert their $1 million IRA and only pay 15 percent. It doesn't work that way," Picker said.

The additional income from the distribution of the traditional IRA would most likely bump you into a higher tax bracket.

CONVERTING WHEN YOUR TAX BRACKET IS LIKELY TO FALL: Not all traditional IRA account holders should convert. Robert Keebler, a certified public accountant and a partner at Baker Tilly Virchow Krause LLP, says it would be a mistake to convert if you are certain your tax bracket will fall in the next few years.

HAVING THE TAXES OWED WITHHELD FROM THE TRANSACTION: Denise Appleby, founder of and chief executive of Appleby Retirement Consulting, says the amount withheld reduces the conversion amount. For instance, if you request a conversion of $100,000 and ask to have 20 percent withheld for federal taxes, then $20,000 is paid to the IRS as an advance payment of income tax for the year. Technically, this amount is a distribution and not a conversion, and $80,000 is converted to your Roth IRA.

You may need to reverse the conversion for several reasons, including if the converted amount lost significant market value. (This reversal is called a recharacterization.) The result of a recharacterization is that the conversion is treated as if it never occurred, for tax purposes. But only the amount credited to the Roth can be recharacterized. For instance, if we use the example above, only $80,000 would be available. You would still owe income tax on the $20,000, because it would be treated as a distribution from your traditional IRA.

CONVERTING TO JUST ONE ROTH IRA: Another mistake, according to Picker, is converting your traditional IRA into an existing Roth IRA account. "Every conversion goes into a brand new Roth account," he said. "You can consolidate later, after the recharacterization deadline."

Indeed, many experts suggest that you convert your traditional IRA into as many Roth IRA accounts as possible, each with investments of a similar type. With Roth IRA conversions, Uncle Sam lets you switch back to a traditional IRA before a certain date should the value of the account fall below the original conversion amount.

FORGETTING TO CONSIDER A RECHARACTERIZATION: Not converting is one possible mistake. Not watching the value of your Roth IRA accounts after converting is a big mistake too, Keebler said. Indeed, there are some tax-saving opportunities that come when the value of your converted Roth IRA accounts falls significantly and you undo the conversion.

According to Appleby, when pretax amounts are converted to a Roth IRA, income tax is owed on that amount. This rule applies even if the market value falls below the taxable amount of the conversion. For instance, if you convert $100,000 in pretax dollars and the market value falls to $50,000, income tax is owed on the $100,000.

"The good news is that taxable conversion transaction can be reversed (recharacterized), if it is done by your tax filing deadline, including applicable extensions. The recharacterization can be done, even if your tax return has already been filed, as an amended tax return can be filed to reflect the removal of the conversion from the individual's taxable income," she said.

Mistakes to avoid when converting to a Roth IRA 01/09/10 [Last modified: Saturday, January 9, 2010 3:31am]
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