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Roth IRA Conversions: Beyond the Basics

The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) went into effect at the beginning of this year and eliminates income limits and allows all taxpayers to convert traditional IRAs to Roth IRAs. Roth IRAs can play an important role in retirement and legacy planning, as they allow for tax-free growth and withdrawals and are not subject to required minimum distributions (RMDs) during the account owner’s lifetime. There are a number of issues to consider resulting from this important change in IRA regulations.

I can’t afford to pay the additional taxes due when from converting.

  • Paying taxes is one of the biggest hurdles associated with Roth IRA conversions and understandably so. But before you dismiss a conversion, remember the new regulations allow for partial conversions. This allows you to establish a Roth IRA with a conversion amount that meets your budget. And taxes due for converted assets in 2010 can be deferred until 2011 and 2012.

I’ve lost too much money in my traditional IRA to even think about converting to a Roth.

  • Converting reduced IRA balances and paying the taxes now will result in a lower tax burden while allowing those assets to recover in a tax-free account. And keep in mind eligible 401(k) and other retirement assets can also be converted directly to a Roth IRA.

What if the market keeps going down and I’ve paid taxes on the higher account balance?

  • Roth IRAs come with a do-over provision called recharacterization, which allows you to convert back to a traditional IRA. Those who recharacterize will receive a tax refund on any tax paid on the conversion, or the tax liability will be removed if they have yet to pay the tax.
  • The IRS also allows time for you to evaluate your conversion decision. For example, if you convert any time in 2010, you have until October 15, 2011, to recharacterize. That is because recharacterization can be done up to the due date of your tax return plus extensions.

I’ve always been told to defer paying taxes for as long as possible. A Roth conversion contradicts that.

  • Tax deferral has been a cornerstone of financial planning. But this is the first time higher income taxpayers can take advantage of the tax-free benefits of a Roth IRA. A Roth IRA conversion is a way to diversify your retirement accounts to address the uncertainty of future tax rates.

It sounds too good to be true. What if Congress changes the rules?

  • If TIPRA is repealed, Roth participants most likely would be grandfathered into the new rules. Although there are no guarantees, this is typically what happens when changes to the tax code modify former tax benefits.

I think my income and taxes will be lower in retirement.

  • No one knows what taxes will be in the future, but current rates are lower than they have been in years. Given the depth of the fiscal crisis, it seems prudent to plan for an increase in federal income taxes. Rising state income tax rates may also be a factor. In addition, depleted retirement accounts could force many people to postpone retirement, resulting in more taxable income than perhaps was originally anticipated.
  • The foresight to fund a Roth IRA today (remember a Roth is not subject to required minimum distributions and distributions are tax-free) could make a major difference in helping you navigate a future retirement made more challenging by higher tax rates and the need to keep working.

Will a conversion have other tax implications?

  • Without question, you need to consider the effects of additional income generated from converting assets to a Roth IRA. This creates an ideal opportunity for you, your financial advisor, and tax professional to collaborate on the benefits and consequences of conversion.

My accountant said it’s not a good idea to convert.

  • Tax professionals generally adhere to the belief it’s always best to defer taxes. However, TIPRA presents a new retirement and legacy planning strategy for high-income taxpayers that merits consideration.
  • Ask your financial advisor to generate a Roth conversion analysis customized to your particular situation. You can share the output with your tax professional to truly quantify if and how a Roth conversion may be advantageous to you and your heirs.

I invest in municipal bonds for tax-exempt income.

  • Distributions from Roth IRAs are tax-free and should be considered in the context of a tax-exempt income strategy. Another major benefit of Roth IRAs is they are not subject to RMD requirements for the Roth owner or their spousal beneficiary. This allows for tax-free accumulation and distribution of assets over many years. Clearly, this type of flexibility needs to be evaluated as part of a long-term, tax-exempt income plan.
  • No conversion strategy is complete without a clear understanding of how those now, tax-free assets will affect your overall asset allocation. How much should be guaranteed? Do you need growth or income from this tax-free account? How will this affect your taxable portfolio? These are compelling and important conversations to have with your financial advisor.

I’m too old to benefit from a Roth conversion.

  • The potential benefits of conversion are unique to an individual’s particular profile and goals. Age is certainly a factor that a Roth conversion analysis should take into account to help you evaluate the opportunity cost of conversion.
  • When it comes to legacy planning, a Roth conversion may appeal to older individuals with large estates who don’t need a traditional IRA for income. Also consider that assets used to pay conversion taxes will reduce your taxable estate and in turn your estate tax. Your heirs will eventually inherit the Roth IRA from which they can withdraw tax-free income throughout their lives.
  • Reducing the uncertainties associated with retirement always makes sense. A Roth IRA‘s tax advantages can play an important role in navigating a future made more challenging by potentially higher tax rates and the need to work longer. Talk to your financial advisor to discuss if the potential benefits of converting assets to a Roth IRA are right for you.

©2009 Lincoln National Corporation This material was prepared to support the promotion and marketing of investment and insurance products. Lincoln Financial Group® affiliates, their distributors, and their respective employees, representatives, and/or insurance agents do not provide tax, accounting, or legal advice. Any tax statements contained herein were not intended or written to be used, and cannot be used for the purpose of avoiding U.S. federal, state, or local tax penalties. Please consult your own independent advisor to any tax, accounting, or legal statements made herein.

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