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Should you switch to a Roth IRA next year?

December 23, 2009 12:00:00 AM PST
A new tax law on January 1, 2010, will allow anyone, regardless of income, to have a Roth Individual Retirement Account (IRA) or to convert their traditional IRA to a Roth. Roth IRAs are popular because you don't have to pay taxes on the money you withdraw at retirement. But switching to a Roth can cost you.If you haven't already, you will begin to hear a lot of ads and pitches to convert your traditional IRA to a Roth IRA. Don't rush to make the change. For some people it can be a good thing; for others it can be expensive.

Even though the Schipper family of Northridge is a young family, they are planning for retirement. Sandy and her husband have been socking away some of their income in a traditional IRA. But now they want to put their money into a Roth IRA.

"It sounds good because you don't get taxed on it," said Sandy Schipper.

Certified financial planner Brian Gilder says Roth IRAs are very tempting because at retirement you can draw money from your Roth tax-free. However, to have a Roth, your adjusted gross income has to be a $100,000 or less. But January 1, that will change.

"January 1, 2010, the government says, 'We need the money, you can convert,'" said Gilder. "So you can convert, regardless of your adjusted gross income."

But just like anything involving the government and taxes, there is no "free lunch."

"The problem is that many people do not realize: You have to pay income taxes. That could push your federal and state income taxes into a higher tax bracket," said Gilder.

"The thought of having to come up with more money on the money that's already mine is really what I don't get. You know, it's my money, why should I have to pay to move it?" said Schipper.

You see, once you take money out of your traditional IRA, the Internal Revenue Service considers it income and so you must pay taxes on it now.

Also, the switch can cause you to lose some of your personal and itemized deductions, triggering additional taxes. Your tax credits could be reduced or lost altogether. Eligibility for college financial aid could be taken away. You might wind up paying that dreaded alternative-minimum tax.

"You have to ask yourself the question: 'How am I going to be able to pay these taxes?'" said Gilder.

"It's all confusing to me," said Schipper.

So here are a couple of reasons a Roth conversion makes sense: If you are in a low tax bracket; if you had a bad business year; if you want to increase your family's inheritance.

And the IRS does say you can spread the taxes over a two-year period.

"It really mostly depends on how much I have to pay on it," said Schipper. "Where I'm going to come up with the money," said Schipper.

If you have plenty of time before you retire, it makes more sense because you have time to make up for the lost tax money.

Just remember, you don't have to make a decision on this right away, so talk to your accountant first.