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7 Myths About Roth IRA Conversions

7 Myths About Roth IRA Conversions

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7 Myths About Roth IRA Conversions
by Kevin McCormallyFriday, October 8, 2010 
Some "expert" advice about whether you should switch is simply wrong.
The hot topic in planning for retirement these days is the special deal Congress is offeringto encourage taxpayers to convert traditional IRAs to the Roth variety. You know the bigadvantage: Money that comes out of a Roth in retirement is tax-free; cash from a regular IRA is taxed in your top tax bracket.With such a powerful payoff, it's no wonder thatthe price of admission is steep. When you switchfrom a traditional IRA, you have to pay tax onany as-yet-untaxed money you move to the Roth (and for most taxpayers, that's 100% of the converted amount).To help investors overcome their innate aversion to paying taxes, Congress concocted atempting deal. For 2010 conversions -- and 2010 conversions only -- you don't have to pay the piper right away. Instead, you may report half the conversion income on your 2011 tax return and the other half the following year.This is also the first year that many IRA owners who can actually afford to switch to aRoth are allowed to do so. Prior to 2010, Roth conversions were forbidden fruit for anyone with adjusted gross income over $100,000. That restriction is now gone.Unfortunately, all the attention on Roth conversions comes with an avalanche of misinformation. Read on as we debunk seven myths making the rounds.
Myth 1: It takes years for a conversion to pay off.
We've seen elaborate mathematical support for the proposition that if you're alreadyretired -- or you're within a few years of retirement -- it's unlikely you'll benefit fromconverting. The reasoning is that it will take years for tax-free earnings inside the Roth tomatch the tax bill you have to pay going in. That seems logical. After all, it's likely tocost $25,000 or more to convert a $100,000 IRA.But remember that the tax bill on the conversion is a bill that you (or your heirs) willhave to pay someday, even if you stick with the traditional IRA. Unless switching to aRoth pushes you into a higher tax bracket than you would be in when withdrawingtaxable amounts from the traditional IRA, a conversion is "break-even financially fromday one," points out James Lange, an attorney, CPA and IRA expert in Pittsburgh. Allelse being equal, you're ahead of the game with a Roth starting on day two because tax-free earnings are better than tax-deferred earnings.
 
But if you pay taxes on a conversion at a higher rate than you would have owed ontraditional IRA withdrawals, it does take time for tax-free earnings to overcome thatdisadvantage. Just how long depends on the difference in tax rates and the performanceof your investments, so making the switch may not make sense.
Myth 2: Reporting income from a conversion will wipe out any chance your childwill get college financial aid.
Sure, colleges take a close look at your tax return when calculating how much help togive your kids. But aid administrators aren't idiots, and they have the leeway to ignore ananomaly -- such as a Roth conversion -- that makes you look richer than you really are.So be sure the college knows what's going on. If you're covered by Medicare, though,you are in a bind. A conversion-induced income spike could indeed push up your 
Part Bpremium for the following year.
Myth 3: This is the only year you get the chance to spread Roth conversion taxesover more than one year.
Although 2010 is the only time you can pay nothing in the year of the conversion -- andthen pay the tax in equal shares the following two years -- there's nothing to stop youfrom gradually converting regular IRAs to Roths over any number of years you choose.For example, if you convert $500,000 in equal chunks over five years, you'd report$100,000 each year and spread the tax over five years, too. Just remember that the sooner the money is in the Roth, the sooner earnings are tax-free rather than simply tax-deferred.
Myth 4: After you convert, you can't touch your money for five years.
This canard grows out of a widespread misunderstanding of the admittedly convolutedway Roth withdrawals are taxed. To withdraw earnings from a Roth tax-free, it is truethat the account must have been open for at least five years. But earnings are the lastthing to come out of a Roth.The IRS assumes that the first money withdrawn comes from annual contributions youmade (and this money can be tapped tax- and penalty-free at any time). Next, you dip intoconverted amounts (always tax-free -- and penalty-free, too, if you are older than 59 or the account has been open for at least five years). Only after you retrieve all of your contributions and converted amounts do you touch earnings -- and if at least five yearshave passed, the earnings are tax- and penalty-free. So, if you convert $100,000 today,you can withdraw it all tomorrow tax-free. The 10% early-withdrawal penalty disappearsonce you reach age 59 or the account has been open for five years, whichever comes first.
Myth 5: You can't spread the tax bill over three years by reporting part of aconversion in 2010 and the rest in 2011 and 2012.
Well, yes you can, if you're married and both husband and wife convert. The law givestaxpayers who convert this year a choice: Report and pay tax on 100% of the conversion

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