by Jim Sandager, MBA, CFP®, Senior Vice President – Financial Advisor, Wealth Enhancement Group

New government regulations will allow more individuals to convert their traditional IRAs to Roth IRAs next year. The new law will also give investors the ability to spread out payment of the taxes that are due on their conversion.

While traditional IRAs are funded with pre-tax earnings and are subject to income taxes when money is withdrawn from the account, Roth IRAs are funded with after-tax earnings and can be withdrawn tax-free during your retirement, after age 59½, or 5 years of opening the Roth, whichever is later. The other advantage of a Roth is that there is no time limit on when you must begin withdrawing your funds, while traditional IRA holders are required to begin taking withdrawals at age 70½.

Individuals who choose not to withdraw their funds from a Roth during their lifetime would also be able to pass their funds onto their heirs income-tax-free, although those funds could still be subject to estate tax.

The new change in Roth regulations will allow all families, regardless of their income, to convert their traditional IRA to a Roth beginning in 2010. In the past, Roth conversions were limited to families with incomes of about $100,000.

The down side to converting to a Roth is that you must pay income taxes at your current income tax rate for the amount you convert, and you must pay taxes with your existing savings since you are not allowed to use your IRA money to pay the taxes.

But there is one other anticipated development that would make conversion in 2010 a more favorable option for high income families. Congress is expected to raise taxes in 2011 for families with an income of over $250,000.

Furthermore, the new law gives individuals some flexibility as to when they pay the taxes on the conversion. If you convert to a Roth in 2010, you have the choice of paying all of your taxes for that conversion as part of your 2010 income taxes or convert in 2010, but pay no taxes on the conversion for that year. Consequently you could pay your taxes on half of the converted amount in 2011 and the other half in 2012 and be taxed at the current rate in those years.

Before you take action, you might consider one other factor; some individuals would be better served to simply forego the Roth conversion and stick with their traditional IRAs. For instance, if you’re currently in a high tax bracket but anticipate moving to a low tax bracket after you retire, you would very likely pay more in taxes to convert now while you’re in the higher tax bracket than you would during your retirement years when you take withdrawals from your traditional IRA.

Lastly, there may be a couple of advantages to converting your IRA to a Roth after you retire. The investments in your Roth can continue to grow tax-free after the conversion and you would not be required to take the mandatory minimum withdrawals after you are 70½ as you must do with a traditional IRA.

The best action may be to talk to your financial advisor or tax advisor to determine what your best option would be on converting a traditional IRA to a Roth.

Article previously published in The Des Moines Register - Sunday, December 13, 2009.