Roth IRA conversion strategies

Thinking about converting to a Roth Individual Retirement Account (IRA) and enjoying a zero tax bracket on all future growth during your life, your spouse's life, and possibly your children's lives?

While many people will make this decision more from their heart than head, one important question to ask yourself is, how long can you keep your money in a Roth IRA? If less than five years, you probably should not convert, unless you're contributing to an existing Roth IRA.

If you decide to convert, here are some other factors and strategies that will help you now and in the future.

Non-deductible contributions - Income limits prevent many people from making tax-deductible contributions to a traditional retirement account. However, if you contribute to a non-deductible traditional IRA, you can convert that traditional IRA to a Roth IRA. In 2010, the maximum permitted contribution to a non-deductible IRA is $5,000 - or $6,000 if you are 50 or older this year.

According to the "Pro Rata Rule," the IRS says when calculating the taxable and non-taxable amounts of a conversion, all of your traditional IRAs, including SEP and Simple IRAs, must be included. Here's the bottom line: You cannot just withdraw or convert the non-deductible fund and pay no income tax, even if the non-deductible IRA contributions were kept in a separate IRA. Any year you make non-deductible contributions, you must file Form 8606 which details the non-taxable portion of your IRA.

Recharacterization - A recharacterization will undo a Roth conversion. It has been called the "do over option," which can be exercised any time before the due date of your income tax return for the year of the conversion, including extensions.

Recharacterizations for 2010 can be made through October 15, 2011. One of the most common reasons to reverse a

conversion is that the portfolio's value has declined after the conversion to a Roth IRA.

First, establish a new Roth IRA to hold each year's conversion amount separate from any of your existing Roth IRAs. This will make it easier to identify the funds being recharacterized. If the funds are commingled, the recharacterization process can become more complicated.

Next, consider establishing multiple Roth IRA accounts if you are converting a large amount of money. If you have multiple asset classes in one Roth IRA, the tax effect of losses and gains are proportional to the account. But, if you maintain multiple Roth IRAs, each with a single asset class (examples: US Large Cap, Domestic Small Caps, Foreign Stocks, Emerging Market Stocks, Commodities, etc.) you can pick and choose recharacterizations to take advantage of the tax break.

For example, let's assume you have $500,000 in your retirement account. You decide to convert $100,000 and set up four accounts, $25,000 in each account. You can keep the best performers as Roth IRAs and recharacterize the laggards back to traditional IRAs.

However, there is another strategy to consider in this situation. "Instead, convert $500,000 to five separate accounts of $100,000. Basically, you will keep the best one and recharacterize the other four accounts," says Barry Picker, Certified Public Accountant, of Picker, Weinberg & Auerbach CPAs, P.C. This will also give you the flexibility to convert more money if it makes sense to do so.

The downside of this strategy, however, is that it involves a lot of paperwork, and you need to keep detailed records. Still, the multiple Roth IRAs don't have to remain segregated forever. Once the converted Roth IRAs are beyond the recharacterization deadline, they can be merged into one account.

Tax Bracket Strategy - What tax bracket were you in for 2009 and where will you be in the year of the conversion?

In choosing the "optimum" amount to convert to a Roth IRA, you would most likely convert an amount that would be taxed at a rate equal to or less than your projected future tax rate. For example, if you are in the lowest tax bracket, your strategy may require a series of partial conversions each year to remain in the 15 percent federal tax bracket.

Be aware: various deductions and credits, such as medical expenses and the child tax credit, may be impacted. Parents of students may find that increasing adjusted gross income will reduce their eligibility for college financial aid and scholarships.

Another important tax consideration is that you must make sure you have funds available in a non-retirement account to pay the taxes that will be due on conversion.

It is important to work with your tax adviser to evaluate all the results of a Roth IRA conversion and see if they will differ if the conversion is shifted from one year to another.

If you are eligible, the advantage of converting for the tax year of 2010 is that tax rates are known. The big uncertainty is what will tax rates be in the future? That is why many taxpayers will pay the tax in 2010 as opposed to splitting the income tax on the conversion between 2011 and 2012 tax years.

Ideally you should convert early in 2010. There is no real advantage to waiting.

Restrictions, penalties, and taxes may apply. Unless certain criteria are met, Roth IRA owners must be 59? or older and have held the IRA for five years before tax-free withdrawals are permitted.

Dan Pinkerton is the founder of Pinkerton Retirement Specialists, a private wealth management firm that Barron's ranked as the No. 1 Financial Advisor in Idaho in 2010, based on assets managed, years of experience, compliance records, client retention reports, types of revenues and assets advised on, and quality of practice. Securities offered through LPL Financial, Member FINRA/SIPC. www.pinkertonretirement.com. Contact them at prs@pinkertonretirement.com