Pros and Cons of Converting to a Roth IRA

The Roth IRA conversion represents a unique opportunity for retirement savers to convert money from a traditional retirement plan that is taxed as ordinary income at retirement time to one that is exempt from taxation. But the decision to convert a Traditional IRA to a Roth IRA could have a serious impact on how much of a retirement nest egg you accumulate, and should not be made without careful consideration.

Significance

• With a Traditional IRA, the contributions a retirement saver makes are deducted from income taxes and are allowed to grow tax-free during the accumulation years before retirement. But after reaching retirement age, all the saver's withdrawals are treated as taxable income. What makes the Roth IRA so attractive is all withdrawals from the account are tax-free, however, the saver receives no income tax deduction on the account contributions during the accumulation stage.

Conversion Could Be Costly

• In order to make the conversion from a Traditional to a Roth IRA, investors are required to pay tax on any untaxed money that will be moved into the Roth account, which could be a high price. Converting a $100,000 Traditional IRA to a Roth IRA costs about $25,000 in taxes up front as of 2010. If money from the IRA is used to pay the taxes and investment returns hover in the mid single digits, it takes 20 years for the net after-tax value to exceed the value of the account if it were left in the Traditional IRA and taxed after the person retires.

Special Advantage in 2010

• People who convert to a Roth IRA in 2010 get a special break. They don't have to fork over the entire tax in one lump sum. The tax code allows anyone doing the Roth IRA conversion in 2010 to spread out the payment of taxes to 2011 and 2012. That means the person who owes a tax of $100,000 due to the conversion could pay no taxes in 2010 and then pay half -- or $50,000 in taxes -- in 2011 and the other half in 2012.

Conversion Makes More Sense For Wealthier People

• Wealthier people are more likely to be able to pay the Roth IRA conversion tax without taking a bite out of the retirement account. The tax-free retirement account can do a lot more compounding if it doesn't have to suffer such a large upfront withdrawal. Also, if a person's tax bracket is likely to be lower at the time they retire, it may not make mathematical sense to do the Roth IRA conversion, because it won't make sense to pay the higher rate now if their tax rate will probably be lower down the road.

The Decision Can Be Reversed

• Anyone who decides to convert a traditional IRA to a Roth IRA in 2010 has until Oct. 15, 2011 to change their mind. If the value of the account falls dramatically, between now and Oct. 15, 2011, it would make no sense to pay taxes on money that has disappeared. Even if the account has grown in value the account owner may get cold feet concerning paying all that tax upfront. If a person changes their mind after paying the tax, they can get their money back from the government by filing an amended return.