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Should You Convert to a Roth IRA?

September 4, 2010

    by John Bearss


    Well Hi Jerry, many people have asked me whether they should convert their Traditional IRA or 401(k) to a ROTH IRA.

    The year 2010 presents a great opportunity for those folks who own a 401(k) plan or a traditional IRA.  Most people who own a 401(k) have never asked their plan administrator if their plan allows them to do an in-service rollover for non hardship cases.  This is an important question to ask because most plans will allow you to roll a portion of your 401(k) to a Traditional IRA so that you can convert it to a ROTH IRA. Information about converting to a ROTH IRA can be found in IRS Publication 590.

    In 2010, if you convert all or just a portion of your Traditional IRA or 401(k) to a ROTH IRA, the portion of the money that you convert is a taxable event, but you can spread the payment of these taxes over the next two years. If a client is under age 59 ½ it is important to note that they need to pay these taxes with money from some other source other than the rolled over money, because if they do they will be charged an extra 10% penalty from the IRS for early distribution.

    Once the money is rolled and converted to a ROTH IRA, you have to leave the money alone for 5 years.  After the 5 year period is complete, one of the following four additional factors must be met to keep the money from being taxed.

    1.      You must be age 59 ½ at the time of the distribution.

    2.      Or the distribution is used for a qualified first-time home purchase.

    3.      Or the distribution is exempt due to disability.

    4.      Or at death, the distribution is named to a beneficiary or estate.

    There are many advantages why converting a portion of your 401(k) to a ROTH IRA is a good idea.  The biggest one that I see is when you start taking an income from your ROTH IRA because it is not taxed for qualified distributions.  Why is this important besides the obvious reason that income tax brackets will probably go up in the future?

    When people retire they generally will start taking their Social Security Benefit.  In 1983, Congress passed a law that started the taxation of Social Security Benefit Incomes for people who make too much “provisional” income.  If a person reaches these income levels they will pay taxes on their Social Security Benefit Income.

    What is “provisional” income?  This is all of the income that a person makes that is reported on their 1040 Tax Form from lines 7 – 21.  Provisional Income would be things like wages, 1099 Interest and Dividends, Earnings from Tax Free Municipal Bonds, Traditional IRA distributions, pensions and even ½ of their Social Security Benefit is used in the formula to determine if a person has reached these income levels.

    The point is, there is no line for income distributions from a ROTH IRA.  So a person can take income from their ROTH IRA and it does not increase their provisional income.  This can help a person reduce or even stop paying taxes on their Social Security Benefit Income.  For a single person you can have $25,000 of provisional income before you start paying taxes on your Social Security Benefit Income.  For a married couple filing jointly that dollar amount is $32,000.

    Let’s take Jeff.  He is a single person who receives $1,000 a month gross from Social Security.  That is $12,000 a year.  Half of that is considered Provisional Income.  So $6,000 of the $25,000 threshold is used.  Jeff also received $1,000 per month gross from a pension.  That is another $12,000 towards the $25,000 limit.  He also takes income from his 401(k) that he didn’t convert to a ROTH IRA, at $600 per month gross.  That is $7,200 annually.  He also received a 1099 statement from his bank for $2,000 annual interest.  If you add all of these up, Jeff’s provisional income is $27,200.  That is over the $25,000 limit and 50% of his Social Security Benefit Income is taxed.

    If Jeff would have converted his 401(k) to a ROTH IRA earlier, the extra $7,200 annual income could have been eliminated. His provisional income would have been reduced to $20,200 which would have kept him under the $25,000 provisional income limit and he would have been able to keep all of his Social Security Benefit Income and not shared it with Uncle Sam.

    I trust this financial insight has been helpful and I look forward to the next time when I can help you provide the foundation for a lifetime of financial independence.

    About John Bearss: John R. Bearss is a Retirement Specialist with the Christian Advisor Referral. He has been helping clients and financial professionals understand financial strategies for 24 years..

    Disclaimer: John Bearss is a registered representative of and does offer securities through Sicor Securities, Inc.  Lifetime Decisions Management, nor it’s representatives provide legal or tax advice.  Please consult your CPA or qualified tax advisor before making any decisions. Lifetime Decisions Management, Inc. is not a subsidiary of nor controlled by SICOR Securities, Inc.

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