Should you convert your traditional IRA to a Roth IRA in 2010?

You'll be hearing a lot in the next six months about Roth Individual Retirement Accounts - but not as much as you should about a long-term threat that hangs over them.

Starting Jan. 1, you'll be able to take a regular IRA, say, one that you have in a brokerage account after having rolled an old 401(k) into it, and turn it into a Roth. You'll be able to do this no matter how much money you make, though you'll have to pay income taxes at your current rate on whatever you move. Currently, you can't make the conversion at all if your household has more than $100,000 in modified adjusted gross income.

Why would you want to make such a swap? Because you think you or your heirs could end up with more money over the long haul by investing in a Roth instead of a regular IRA.

With a Roth IRA, you pay no taxes on your earnings in most instances when you take money out; distributions from regular IRA's are taxable the same way that income is, though the basic IRA does offer a tax deduction when you first deposit money into the account. The Roth offers no such deduction when you contribute money to it.

So if you think your tax rate will be higher during retirement than it is now, say if you're fairly young for instance, making the conversion early in 2010 looks sensible.

It all seems pretty simple, until you consider this: The tax laws might change substantially, throwing all of your careful planning into utter disarray. We're currently staring down years of federal budget deficits and decades of looming Medicare and Social Security obligations. If wealthy people convert their retirement funds to Roth IRA's in large numbers, won't all of that newly tax-shielded money look tempting to government officials years from now?

There is no way to know, and admitting the futility of making a specific prediction is where you have to begin this analysis. After all, if you get serious about your money at 40 and live until you're 90, that's a half-century for which you need to plan.

Still, many financial planners are concerned enough about the possibility of huge changes in the Roth rules that the looming opportunity in 2010 has inspired an orgy of spreadsheet creation and client outreach. Think all of this activity is simply an attempt to stoke fear among investors and charge fees for alleviating it? That would make you as cynical as all of the people who are certain that Roths are a big lie and the tax-free earnings simply cannot stand for more than another few years. Neither is likely completely correct, so let's take a quick look at both arguments before trying to figure out what to do with your own IRA.

How Roths Might Change

At the most extreme end, the federal government might try to tax the earnings on a Roth after all, say through the capital gains tax, which is currently at 15 percent for long-term gains but could go up in the next few years. Or it might levy some sort of an excise tax on excessive balances, however those might be defined.

Roths are especially useful for estate planning purposes. Regular IRA holders have to start taking money out once they reach the age of 70 and a half, but Roth owners don't have to take money out during their lifetimes. Heirs of Roth holders, meanwhile, pay no income taxes when they cash out of the inherited account and can spread those distributions over an entire lifetime, allowing for decades more of tax-free growth thanks to the wonders of compound interest. Some part of this could certainly change.

Why Roths Won't Change

Those who think the taxes on Roths won't change anytime soon point first to politics. Given the trouble that President Obama is already having getting parts of his agenda through a Congress controlled by his own party - Democrats have big majorities in the Senate and the House - it's hard to imagine him successfully making substantive changes to the Roth. After all, many of the lawmakers who voted for it are still there.

Others make a fairness argument (It would be double taxation!), or a legal one (The no-tax promise of Roths is a contract!) or a practical one (No one, including the IRS, would want to be the record keeper or track the details, because grandfathering everyone would be so complicated!).

What You Should Do

If you're considering a conversion - and just about everyone who has an IRA ought to think about it - start with a handful of basic questions. First, can you afford the income taxes you'll have to pay on whatever amount you convert? If you can't come up with the money, you can stop right here. Taking it out of the IRA before turning it into a Roth is a terrible idea, given potential penalties and the loss of tax-free future growth that would result from using some of your IRA savings to pay for the taxes.

If you can get over that hump, how much money do you think you'll have come retirement? How much do you think you'll need to live on? How much might you want to pass on to heirs? And are you close enough to retirement to have any clarity on how the answers to these questions might affect the amount of taxable income you'll have?

This is simply a starting point, and it can quickly get more complicated for any number of reasons. If you want to fiddle with your own numbers, there's a decent calculator at rothretirement.com (click the "Calculator" tab), though it doesn't allow you to adjust for possible Roth tax changes. But given the size of the balances involved for many people, this would be a good moment to get some professional advice, preferably from a certified financial planner with deep tax knowledge who agrees to work as a fiduciary (i.e. in your best interest).

Even with possible tax changes, the path may be clear for some investors, especially older ones who might be spared any big alterations that occur two decades from now. For everyone else, however, it's best to think about tax diversification in the same way you think about asset allocation. It's about spreading your risk and your money.

As always, you can reach me at wlam@adelphiretirement.com or contact number at 925-212-1727. Please visit my company's website at www.AdelphiRetirement.com.

Wai-Yew Lam, Principal