I’m sure a lot of you are reading the headline above and thinking “Say wha?”
Let’s back up. There are (generally) two types of IRAs, which stands for Individual Retirement Arrangements (Yes, “Arrangements” and not “Accounts.” Look it up). There is the “Traditional” IRA and the Roth “IRA”. (Also note that Roth is not written in all caps as it’s not an acronym but named after the late Sen. William Roth of Delaware).
Without going into more specific detail, the contributions to a traditional IRA are generally deductible, but the distributions are taxable income when withdrawn. On the other hand, with a Roth IRA, the contributions are with after tax money, but the withdrawals are tax free. There are other advantages to the Roth, including the fact that the owner is not required to start taking minimum distributions at the age of 70 1/2.
There are income limitations as to who can contribute to a Roth IRA, and who can convert their traditional IRA to a Roth IRA. In 2010, the income limitation preventing wealthier individuals from converting their traditional IRA to a Roth disappears. Anyone can convert their traditional IRA to a Roth, but they have to recognize the amount converted as taxable income. In other words, if your traditional IRA is worth $100,000 at the time of conversion, then if you convert you will have $100,000 in additional income, subject to taxes. There is a special rule for those that convert in 2010, allowing them to spread the taxes owed over 2 years.
I’ve seen numerous articles on the internet and have heard a few presentations debating who should convert their traditional IRA to a Roth and who shouldn’t. These articles state that a number of factors should be looked at before converting: (1) the person’s age; (2) the person’s tax bracket; (3) whether they can pay for the conversion from funds outside of the IRA; (4) how long they have until retirement; (5) whether they think they will have a higher or lower tax rate in retirement.
All of this is true, and all of those factors should be examined. But they should be examined after everyone converts on Monday, January 4, 2010. Why? Because if you convert you have until October 15 of the following year (i.e. October 15, 2011) to undo it (known as a recharacterization), penalty and consequence free. You can even do a partial recharacterization, meaning some of the IRA will stay as a converted Roth IRA and some will go back to the traditional.
The amount of income that you are required to recognize for tax purposes, is the value of the traditional IRA at the time of the conversion. If you wait to convert, you are risking missing a substantial increase in the market. If the market goes up, it could cost you substantially more in taxes to convert than it would have if you had not waited. If the market goes down, or, if based upon the above factors you later decide that converting was not the best option for you, you have almost two years (if you convert in January) to change your mind. Not only that, you can still reconvert to a Roth IRA, provided that the reconversion is not in the same year as the initial conversion and not within 30 days of the recharacterization.
So I think everyone should convert their traditional IRA to a Roth IRA in early January of 2010, and then they should wait and see whether or not it was a good choice, because believe it or not, Congress is giving you a do-over.