What You Need to Know About Roth IRAs in 2010

According to a September 29, 2009 Fidelity Investments study, 88% of respondents are unaware of the 2010 Roth conversion opportunity.

The what opportunity?

With only 12% who are aware of this, chances are good you need a crash course in what exactly has changed in 2010 regarding the Roth IRA conversion opportunity and why it matters to you.

What is a Roth IRA

First, let's start with the basics. I run into quite a few people at my day job who are unaware of what exactly a Roth IRA even is. Most folks have heard of it, but are unsure of how it works. Some of you might be asking, “what is a Roth IRA?” It's OK, you’re not alone — here's the basic gist:

A Roth is an Individual Retirement Account that is funded with after-tax contributions; the money grows tax-deferred; and withdrawals are TAX FREE!

Think of it this way — already taxed money goes in and comes out completely free of taxes. It's a pretty sweet deal if you qualify and meet the specifications. Some of the specifications include income limits and number of years account is opened. Roth IRAs have been around since 1998 and have grown in popularity since.

What is a Roth IRA conversion?

How would you like to take money from a fully-taxable account and put it into an account where it's tax-free for life?! That's exactly what a Roth conversion is. It's simply converting your money from a Traditional IRA to a Roth IRA.

The problem is that whenever you do this you have to pay taxes on the amount you withdraw and convert from your Traditional IRA. (What — you think Uncle Sam would let you off the hook?) So, for example, let's say you want to convert $10,000 from your Traditional IRA — you would have to tack that 10 G on to your income for the year and pay tax at whatever rate you are at. (It's as if you earned an additional $10,000 of income.)

What is the opportunity?

There's been plenty of talk regarding the 2010 Roth conversion opportunity, which is why I'm surprised by the Fidelity study. One big change for 2010 and beyond is that anyone can convert to a Roth regardless of income level. Previously, if you made over $100,000 you could not convert to a Roth. (As a side note, that rule never made sense to me because the IRS would get more in tax revenue from folks who are making more money because they are in a higher tax bracket.)

The opportunity for 2010 is that you have a choice to pay all of your taxes in 2010 or average the taxes owed on the conversion over two years (i.e. pay in 2011 and 2012). It's not often that the IRS gives you a choice on when you can pay your taxes. (One additional note: 2010 is the last year for the current low income tax rates. The current law plans for higher tax rates in 2011 — so, if you chose to average your tax payments over the two year period in 2011 and 2012, you might get hit with higher tax rates.)

Why does this matter?

This matters because for some individuals who are laid off, not working as much, receiving a lower income, or retired (to name a few scenarios) — this might be a great time to convert your money to a Roth and potentially pay lower taxes than you would normally. Also, although the markets have rebounded significantly, account balances are still off their highs, which means that converting when accounts are low will result in less overall tax being paid. If you get that money into a Roth, all the earnings and growth you receive will be tax free!

Roth IRAs are great retirement tools that are worth a look to see if they make sense for your situation either through regular contributions or through a Roth IRA conversion. Be sure to review the rules and regulations to make sure a Roth IRA conversion is right for you in your quest for retirement.

This is a guest post from Jason @ Redeeming Riches. Jason is a Certified Financial Planner by day and a personal finance blogger by early morning and writes to help others Restore Their Money and Renew Their Minds. Subscribe to his posts. Check out other great posts from Jason:

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Guest's picture

I think you need to clarify on the taxes. For most people, who put money into a regular IRA (at least the last 10 years), did so because they were over the income limits and unable to contribute to a Roth IRA. I put in after-tax money into my traditional IRA & I will ONLY pay taxes on the gains that I have made in the last few years. I do NOT pay taxes again on the original contribution amounts since I didn't deduct them originally.

Guest's picture

That is correct and a good point. You do not have to pay taxes on any "after-tax" amounts in the non-deductible IRA .. only the gains would be taxable in that scenario.

If 2008 wiped out a lot of those gains, a Roth conversion might make sense in that you can then get that money into a tax-free account and any gains from here on out will be entirely tax free.

Guest's picture

Most people who post on the subject of Roth and conversions to Roth have been brainwashed and are lemmings being spoon fed a bunch of garbage.

The government wants you to believe Roth is so wonderful and is making it so easy for everyone to convert for one reason and only one reason - they cannot stand the fact that there is all of this traditional IRA and 401k money out there that they cannot get their hands on. Our country is running massive deficits like never before, the Treasury is printing up money like there's no tomorrow, and here's all this money stashed away for the past 25 or 30 years that's never been taxed and may not be taxed for another 20 years more.

You are being urged to convert because they want your tax dollars today. If you believe that the government is doing this for your personal benefit, think again.

For the vast majority of people with money stashed in a 401k or traditional IRA, they will be better off just leaving the money there as all of the reasons it was put there in the first place still hold.

The point made in this article that if you've been laid off or are out of work and because your income is now lower, converting may make more sense is also hogwash. Where is the money going to come from to pay the taxes when the conversion is done? That unemployed person has little/no income and isn't getting any usage out of the converted funds - lest you think it's a good idea to pay the taxes out of the money being converted? Hey - by the same token, maybe you want to make the argument that since the economy and markets are down, and most people's retirement funds have not recovered and are still down a fair amount of money, it likewise is a good time to convert - because there will be less taxes to pay because you have less money?

Don't be brainwashed. Roth conversion is not a good idea for most people. It makes sense only to those who will be taking a chunk of your money NOW.

Guest's picture

I don't argue that the government is allowing these for our benefit, we all know it's to generate tax revenue for them - but so what...if it makes sense for some financially, then take advantage of it. win/win.

I do not suggest that a Roth conversion is beneficial for everyone or even that it be something everyone should do.

At the very least, I suggest running some numbers and making an informed decision whether this is right for your situation.

Guest's picture

As of today, Wisconsin has not adopted to new rules regarding Roth IRA's. Here is a link that explains more from the Wisconsin Department of Revenue: http://www.revenue.wi.gov/taxpro/news/091030.html

Guest's picture

I've been looking for an answer to this and haven't found it anywhere. I opened a traditional IRA in 2007 with after-tax money. Due to the stock market drop in 2008 there is less in the account now than I originally contributed.

Will I be able to deduct the net loss on my 2010 taxes if I convert? Logically it would make sense that the losses should be deductible (just as gains would be taxable), but I haven't been able to figure out whether the IRS allows it, since all the guidance I've seen assumes that conversions involve net gains.

Guest's picture

@howeezy: Thanks for the link. It was interesting, but it deals with deducting losses on withdrawals--not on conversions.

I think I've answered my own question, though, by looking at IRS Form 8606 (I looked at the 2009 version, but I assume 2010 will be the same). The answer is that you cannot deduct net losses on conversion (see line 10 of Form 8606, which effectively limits the nontaxable portion of the conversion to the amount of the conversion). The leftover basis, however, continues to carry forward.

So, for example, say I contributed $4000 after taxes in 2007. In 2010 I go to convert and the account is only worth $3000. I don't get to deduct the $1000 loss on my 2010 taxes. But if I later contribute more money to a traditional IRA, I won't be taxed on the first $1000 in gains when I withdraw or convert that.

Guest's picture

A Roth is also great for paying for unexpected medical expenses. Not that I would recommend that, but I am young and was forking out 15%-18% in credit card interest I used to pay the bills, so I figured it'd be worth it to cash out and pay them off.

Back to square one!

Guest's picture

I have Roth IRAs funded between 2006 and 2009 in a variety of mutual funds. Some will convert at a gain and some at a loss. Will I be taxed on the net gain of all of them combined or taxed individually on only the gains?