2010 is almost here and Roth IRA conversion fever which I could never comprehend, is heating up. For those who do not know, Roth IRA was established by the Taxpayer Relief Act of 1997 and named for its chief sponsor, the late Delaware senator William Roth. A Roth IRA is an Individual Retirement Account, contributions to which are not tax-deductible but withdrawals can be tax-free under certain conditions. The key benefits and disadvantages when compared to Traditional IRA, will be hopefully listed in separate post. Here we are only dealing with Roth IRA conversion in 2010, income limit, eligibility and few key points.

Rules, income limit and eligibility
Starting January 1, 2010, the income limit for Roth conversions will disappear. The $100,000 Modified Adjusted Gross Income (MAGI) limit that has prevented many from converting traditional IRAs into Roth IRAs will be gone. Moreover, married couples filing separate tax returns also will now gain eligibility to convert. For direct contributions however, no changes planned from 2009. Single investors with MAGI below $120,000 or married couples with MAGI below $176,000 are eligible to contribute.

Those electing to convert, will be able to spread any taxable income created by the Roth IRA 2010 conversion evenly across 2011 and 2012, unless they choose to recognize the entire income in 2010. Such two-year option is only for 2010 conversions. December 31, 2010 will be the last day to initiate a Roth conversion distribution to be reported for the 2010 tax year. For conversions made after this date, there is no option to spread the income over subsequent years for tax purposes. Taxes on conversion income will be owed for the year of conversion.

Convert on not convert
Now is the obvious question, should you convert in 2010? Should you forfeit tax deferred contributions you enjoy today with a Traditional IRA, for eligibility of tax-free qualified withdrawals from a Roth IRA someday in the future? With a traditional IRA, your earnings grow tax-deferred until the withdrawals are made. Then you pay income taxes. In addition, account owners must take required minimum distributions (RMD) beginning at age 70½.

In a Roth IRA you invest money that has already been taxed since there is no tax deduction for Roth contributions. Thus you do not owe any income tax on future qualified withdrawals as your contributions are made with after-tax dollars. And with Roth IRA conversion you do not have to take RMD during the lifetime, and your money can grow further tax free.

Here are 5 main points you should know about Roth IRA conversion rules and facts,

1. You have to pay taxes on the amount you convert in return for the potential future tax breaks of a Roth IRA, when you convert. That means if you have money in a traditional IRA that you have not yet paid taxes on, you could have a substantial hit. If you are in the 28% tax bracket, you are likely to part with $28,000 after a conversion of $100,000. So such a conversion may only benefit you in the long run if you expect two unlikely things to happen. First, you will be taxed at a higher rate when you retire. Second you invest wisely and make money. On a second thought, the way we are going, higher tax rates may just happen.

If you expect your income tax rate will be lower, conversion will likely lose you money. If you are not sure what your future tax rate will be, you may think of converting a part of your traditional IRA to a Roth for tax diversification.

2. If you do not have money available outside of your IRA to pay taxes on the conversion, do not convert. Pulling money out of your IRA to cover taxes will likely defeat the purpose of making the switch to begin with. By reducing your retirement savings, you reduce your ability to generate future tax-free earnings on money invested in the Roth. In addition, if you are under age 59½, the amount pulled out of your IRA to cover the taxes may be subject to a 10% IRS penalty. A cash account is generally the best place to get the money to pay the taxes on the conversion. But then again, if you have so much cash, buying gold may be much better option.

3. If you do not have enough money to pay taxes on converting all your traditional IRA assets, or if doing so would push you into a higher tax bracket, consider converting just part of your Traditional IRA. Also a special provision applies to 2010 Roth conversions that gives you the option of postponing the tax bill and paying it off over 2 years by splitting the taxable income earned from the conversion, evenly between 2011 and 2012. Then again, tax rates are scheduled to go up in 2011, so you will be paying taxes at a higher rate.

4. Do not convert if you expect start making withdrawals within 5 years as you will only be able to withdraw earnings from the account without taxes and penalties if you are age 59½ or older and you have had the Roth IRA for at least 5 years. Your original conversion amount is tax-free. But to avoid a 10% IRS penalty, you must be either at least age 59½ or wait at least 5 years after your conversion to make the withdrawal.

5. You can leave entire accumulated amount to your heirs, since with a Roth you do not have to take money out. Unlike with a Traditional IRA, there are no RMDs. And while your heir most likely will be subject to RMD, he or she can withdraw the amount of your original conversion tax-free. Any earnings are also tax-free, provided that the Roth IRA meets the five-year holding requirement.

So with a few nice things regarding Roth IRA conversion in 2010, do consult your accountant, tax advisor or financial planner. Now that I think of it, you should consult all three.

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