Most people hate to pay taxes -- and if you hate paying them now, wait until they start going up. You're sure to hate them even more.
That's why now is the time to give serious consideration to converting at least a portion of your retirement savings into a Roth IRA, one of the best defenses against potential future increases in federal and state income taxes.
With the Roth IRA, there's no tax savings on the front end as with other retirement savings accounts, but it allows for years of tax-free growth followed by withdrawals in retirement that are entirely free from taxation. Imagine paying no income tax in retirement.
Roth IRAs can be funded by annual contributions or a conversion from existing retirement accounts.
If you convert to a Roth IRA, you pay taxes upfront on the conversion amount in return for avoiding income taxes down the road. The hope is that the future tax savings will far outweigh the cost of conversion.
The Roth IRA has been around in this form for years, but a change set to take effect Jan. 1 will allow more taxpayers than ever to enjoy its benefits.
On that date, individuals and couples who make more than $100,000 a year will be eligible to convert existing savings now sitting in a traditional IRA or some other retirement plan to a Roth IRA. Currently, such conversions are restricted to those under the $100,000 income level.
This elimination of an income cap for conversions will primarily benefit higher-income taxpayers who have been cut off from the Roth's benefits, but there's something in it for lower-income individuals as well.
A special 2010 incentive provided by Congress will allow anyone who converts to a Roth next year to delay paying taxes on the conversion and spread them out over the 2011 and 2012 tax years.
This one-year deal -- aimed at providing a temporary boost to federal tax revenues -- applies to everyone, regardless of income.
What this all means for individual investors is that they will be hearing a lot about Roth IRA conversions over the next 13 months. There will be a nonstop stream of advertising and media coverage discussing both the pros and cons of Roth IRA conversions.
The basic question for individual investors is whether the upfront tax costs of conversion will pay off in the long run. There's no easy answer to that question, and it's different for every taxpayer.
That may be why so few individual investors realize what's happening in 2010.
A survey in August by Fidelity Investments found that nearly 90 percent of individual investors were unaware of the 2010 Roth conversion opportunities. The survey also found that a high percentage of investors lack a basic understanding of how Roth IRAs work. For instance, 66 percent of the respondents to the survey incorrectly thought that withdrawals from a Roth IRA must begin before a person reaches age 70-and-a-half. (That is true of conventional IRAs.)
In fact, one of the Roth's great benefits is there no requirement for minimum withdrawals at a certain age as there is with a traditional IRA or most other retirement savings accounts. This makes it a great vehicle for investment assets someone wishes to leave to their children or other heirs.
"It was amazing to me how folks were uncertain of the benefits of a Roth IRA," said Chris McDermott, Fidelity's senior vice president of investor education, retirement and financial planning.