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AMY FELDMAN

Big benefits possible in converting regular IRAs to Roths

Many taxpayers are delaying year-end decisions until they see what Washington does with a host of expiring tax measures, including those affecting dividends and capital gains. Yet one of the biggest year-end tax moves is relatively absent from the headlines: whether to convert a traditional Individual Retirement Account to a Roth IRA.

The Roth IRA is partly a play on ­income-tax rates: You contribute to it with after-tax money and don’t owe income tax again. If you expect your personal tax rate to be higher when the money comes out than it was when it went in, it’s a better deal than a traditional IRA, which allows you to defer the tax hit until you make withdrawals in retirement.

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Tax gurus love Roths, but such accounts made up just 6 percent of the $4.9 trillion in IRA assets at the end of last year, according to the Investment Company Institute. A lot of people may want to consider converting at least part of their IRAs into Roths, because you will not pay taxes on the earnings in your Roth account as long as you wait until you’re over age 59½ and the account is at least five years old before you make withdrawals.

Younger people can do much better with a Roth because earnings may outstrip initial contributions. The longer you leave money in a Roth, the better.

The biggest benefits go to those who use Roths for estate planning and do not need to tap the accounts. Roth IRAs are not subject to rules that force traditional IRA holders to begin drawing down assets at age 70½. Account holders who never use the money and bequeath it to their children or grandchildren will be transferring those tax-free breaks to younger generations.

This is why tax advisers often recommend that wealthy older people who expect to leave an inheritance use a Roth IRA as a simple, tax-efficient way of passing on money. However, Roth IRA balances are included in tallying estates for estate tax purposes.

“We did quite a bit of modeling on Roth conversions, and what we found is that the conversion is beneficial, but in many cases the break-even period is about 20 years,” says Richard Baum, a tax partner at Anchin, Block & Anchin in New York. “If a client wanted to do the conversion for the benefit of a grandchild, that would make sense. But you do need a long period of time to recoup the tax costs.”

An online Roth IRA conversion calculator can help you make the decision. You may want to ask a tax adviser for a more personalized analysis.

For some people, doing a Roth conversion will move them into a higher tax bracket. How much tax you will owe on your 2012 federal tax returns depends on what type of IRAs you hold. Over the years, some people have made after-tax contributions into traditional IRAs, so it is possible to have a fully tax-deferred IRA or one that is only partially tax-deferred.

If you own only IRAs that have been funded with nondeductible contributions, then you will owe tax on the earnings only. But if you have only IRAs with deductible contributions, you will owe tax on the full amount you convert, since you contributed on a pre-tax basis. If you contributed both ways, you must figure out your tax hit based on the pro-rata share of each.

Amy Feldman writes for Reuters.
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