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If your traditional IRA has lost some of its value as a result of recent stock market declines, now may be the time to consider converting it to a Roth IRA to turn your paper losses into a long-term tax savings.
The Roth IRA may be a more attractive retirement savings vehicle for you because even though contributions to a Roth IRA are not deductible, the Roth IRA offers tax-free growth of your investment as well as tax-free withdrawals if you are over 59 1/2 years old and have owned the account for at least 5 years.
In contrast, withdrawals from a traditional IRA are subject to ordinary income tax and require owners to begin taking "required minimum distributions" (RMDs) at age 70 1/2. There is no mandatory rule requiring RMDs from Roth IRAs. This means that you have the option of leaving the money in the account to grow tax-free until it's needed.
The downside to making the conversion is that the amount converted from the traditional IRA to the Roth IRA will be taxed as ordinary income in the year of the withdrawal. The good news is that the 10 percent premature distribution penalty will, however, not be imposed regardless of your age at the time of the conversion.
Converting to a Roth IRA when the value of the stocks in the traditional IRA is low will save you taxes because the total value of your traditional IRA less any nondeductible contributions will be taxed as current income when you make the conversion to a Roth IRA.
Consider the following example to appreciate the tax savings of making the conversion at a time when the value of your traditional IRA has declined as a result of poor stock market performance.
Example: Jack Weber is in the 38.6 percent tax bracket for 2002. He has made fully deductible contributions to his traditional IRA every year. He invested the money in highly speculative technology stocks. The value of his IRA has plummeted from $100,000 to $50,000.
If Jack converts to a Roth IRA in …