Top5 Reasons to Convert Retirement Savings to a Roth IRA

By AnnaMaria Andriotis,

Seeking to recoup the losses in your retirement portfolio as quickly as possible is an understandable pursuit. But rather than making a rash decision – like trying to time the market or completely withdrawing your funds and stashing them in a non-interest bearing savings account – consider an option that offers more perks than risks: converting a portion of your nest egg to a Roth Individual Retirement Account (IRA).

With a Roth IRA, you get taxed on your contributions but can make withdrawals tax free once you hit age 59 ½ (you also have to held the account for at least five years.) Typically, this tax perk works best when the person contributing to the Roth IRA is young and in a lower tax bracket. Therefore, they don't have to pay much in taxes upfront, says Pam Hess, director of retirement research at Hewitt Associates, a human resources consulting firm.

But as a growing number of people find themselves unemployed -- and all of a sudden in a lower tax bracket -- and portfolio balances continue to shrink, now may be a great time to rollover existing retirement accounts into a Roth IRA.

Here are five reasons why you should consider converting to a Roth IRA soon:

1. Shrinking Retirement Portfolios

Seeing your traditional IRA or 401(k) shrink by 30% in a year doesn't give you much to smile about. But believe it or not, there is a silver lining: If you convert a portion of these accounts to a Roth IRA now, you'll pay less in taxes.

When you convert part of your IRA or 401(k) balances to a Roth IRA you pay taxes on the amount being converted. Since account balances have been decimated, the amount you would pay taxes on now is likely to be considerably lower than it was when the market was stronger. So basically, this an opportunity to use the market downturn to your advantage, says Linda Robertson, a Philadelphia-based fee-only certified financial planner with Financial Finesse, a financial education company.

(Click here for some new tax breaks and here for how you can deduct your IRA losses.)

2. Potentially Higher Tax Rates

All of those stimulus package initiatives and government bailouts are going to cost money. And, as a result, today's tax rates might be the lowest you'll see for the rest of your life, says Robertson. "The consensus is that we may see taxes rise – but no one knows how much," she says. If you are considering converting to a Roth IRA you should get a move on – especially if you're young, recently took a pay cut or were recently laid off and are in the 10% or 15% tax bracket. In a year or two you may be in a higher tax bracket as a result of a new job or salary increase, so it's best to take advantage of your low tax rates now, says Sheryl Garrett, a fee-only certified financial planner.

3. Income Rules Get Wiped Out Next Year

High-income earners will also have a momentary shot at taking advantage of the Roth IRA's perks -- as long as they are willing to wait. Come 2010, anyone can convert a portion of their traditional IRA or 401(k) into a Roth IRA regardless of income.

Currently, conversions are only an option if your modified AGI – not including additional taxable income triggered by the conversion itself – is $100,000 or less. Married individuals who file separately are ineligible regardless of their income. (To contribute as opposed to convert to a Roth IRA, single filers need an adjusted gross income (AGI) of below $120,000 and those who are married filing jointly need an AGI below $176,000. The maximum contribution is $5,000 a year – or $6,000 for those who are at least 50 by year-end.)

But don't stall. This $100,000 restriction will be lifted only for 2010.

4. You Can Spread the Conversion Tax Hit Over Two Years

Another new perk coming next year: deferred taxes. Those who convert to a Roth IRA in 2010 can spread their tax liability out across 2011 and 2012 thereby reducing some of the immediate tax hit, says Petra Campos, a retirement director for Charles Schwab. They'll pay half the income they convert in 2011 and the other half in 2012 at whatever tax bracket they're in during those years, says Garrett.

Click here for more perks to converting to a Roth IRA.

5. Estate-Planning Benefits

Wouldn't it be great to reach your 80s or 90s with enough cash to leave to your children? Well, if that's your goal, then the Roth IRA offers some pretty generous estate-planning benefits, says Robertson.

When a traditional IRA or 401(k) is passed on to a beneficiary, the beneficiary has to pay taxes on whatever is left in that nest egg based on their tax bracket – not the tax bracket of the original account holder. With a Roth IRA, the beneficiary acquires the account without having to pay taxes on the cash that's left. The reason: You already paid taxes on the contributions.

The Roth IRA also doesn't require minimum withdrawals, so you can presumably leave the entire nest egg untouched for a beneficiary, says Campos. Typically, traditional IRAs require minimum withdrawals by age 70 ½.

Click here for more on minimum required withdrawals and here for tips on managing your estate plan.

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