It is 2010, and for people who have a traditional IRA (Individual Retirement Account) this is your lucky year; Uncle Sam is offering the deal of the decade!  Starting January 1, 2010 traditional IRA holders will have the opportunity to move money, without restriction, to a Roth IRA where money can grow TAX FREE (until you withdraw it!)

Essentially a Roth and traditional IRA are meant to do the same thing; provide people with a place to save money for retirement.  However that is about the only thing they have in common.  There are many differences between the two, but income restrictions are the most important to consider during 2010 because the changes the restrictions will undergo.  Investing in a traditional IRA’s has no income restriction; a person can make as much money as he or she wants and can open up a traditional IRA.  For Roth IRA’s there are restrictions: individuals who have an AGI (Adjusted Gross Income) that exceeds $120,000 and couples that have an AGI exceeding $176,000 are restricted from opening a Roth IRA.  Also, individuals with an AGI of more than $100,000 and married couples filing separate returns cannot move assets from their traditional IRA to a Roth IRA.

In 2010 the income restrictions for individuals and couples will remain the same, but Uncle Sam is permanently (well, as permanent as any tax code item is!) eliminating the income and filing status restrictions on transferring money from a traditional IRA to a Roth IRA.  Basically, starting January 1, 2010, individuals with an AGI of more than $100,000 and married couples filing separate returns WILL NOW be allowed to move their money from a traditional IRA to a Roth IRA. What a deal!  Here’s why:

1. Withdrawals from a Roth IRA are tax free for 5 years after the transfer, or after the individual turns 59 ½ years of age, (whatever comes first) is thed time frame when withdrawing money without a penalty can occur.  Traditional IRA withdrawals are not tax free; every withdrawal made is taxed.
2. A Roth IRA has NO required withdrawals, which allows a persons’ money to grow tax free without being touched.  With a traditional IRA withdrawals are mandatory after the age of 70 ½ years old, and people have to pay taxes on those withdrawals.
3. Another advantage a Roth has over a traditional IRA occurs when leaving accounts to a heir.  Whether it is a traditional or Roth IRA the heir must make annual withdrawals from the account that is given to them.  The advantage that Roth has over the traditional IRA is that although money has to be withdrawn annually, no income tax has to be paid on the withdrawals.

Unfortunately, this is not as simple as moving money from one account to another and that’s it; there is a cost to converting the money: an “income-tax bill.”  Every time money is withdrawn from a traditional IRA, income-tax must be paid on the withdrawal.  Essentially, when moving money from a traditional IRA to a Roth IRA a person has to pay income tax on the conversion.  To help determine the amount of tax that will be on the money conversion, use the Roth conversion calculator provided here: Roth IRA conversion calculator!

Although there is a cost to converting, Uncle Sam has a special offer for people who do choose to convert their money in 2010!  Those who choose to convert their money in 2010 will have the option to put the amount converted on their 2010 tax return, OR have it spread out equally among their 2011 and 2012 returns.  So, instead of paying income tax on the whole conversion amount in one year, a person has the option of spreading the payment out to two years.   Due to the risk of Congress increasing tax rates, it may be beneficial to put the conversion amount on the 2010 tax return to avoid possibly paying higher taxes on the amount in 2011 or 2012.

There are a myriad of other reasons one may wish to convert than those listed above. If the value of a traditional IRA has fallen, the tax on the conversion of a lower asset base may make this attractive if an investor wishes to reinvest in the same securities. Discuss the particulars with your Financial Advisor before making any transfer of assets to a Roth, but 2010 is the year to do it if you choose to take advantage of this new opportunity to shelter money!

Tags: Roth IRA conversions, Traditional IRA