The hottest topic in the financial planning world lately seems to be the new tax rules that go into effect in 2010 regarding Roth IRAs. Starting January 1st, everyone with earned income can contribute to a Roth IRA: there are no income limits restricting who can contribute and who can’t. So, working physicians with modified adjusted gross incomes over $100,000 can, for the first time in 2010, contribute to a Roth IRA ($5,000 annually if you are under Age 50; and $6,000 for those over Age 50). (Roth factoid: you don’t get a deduction for contributing to a Roth IRA, but you generally don’t pay income taxes when you draw out of a Roth IRA either – see below).
An even “hotter” subtopic seems to be the opportunity in 2010 to convert a traditional IRA to a Roth IRA to enable one to have a retirement asset that will be free of income taxes “down the road.” To get there, however, you generally must report the amount converted as income in the year you convert and pay the resulting income taxes upfront. There is a special tax incentive for those who choose to convert during 2010. For conversions that are made during the 2010 calendar year, federal law allows taxpayers to delay taxes by electing to include the taxable portion of the 2010 conversion ratably in taxable income for 2011 and 2012. With the stock market depressed and tax rates relatively low, financial planners say now might be a good time for certain investors to convert their traditional IRA to a Roth IRA.
A Roth conversion comes with plenty of benefits. For instance, you aren't required to take a minimum distribution from a Roth IRA at Age 70 1/2 as you are with a traditional IRA. Beneficiaries of Roth IRAs generally do have to take an annual minimum distribution (or RMD) (which is non-taxable); however, the original owners donot have to take them. Therefore, Roth IRAs are often viewed as the perfect type of retirement account to leave to one’s heirs for estate planning purposes. Most importantly, the growth in these accounts over time is not taxable and owners of Roth IRAs can take tax-free distributions after age 59 ½.
However, there are downsides to doing a Roth IRA conversion. The biggest one is that you have to pay a tax on the distribution from the traditional IRA as part of the conversion process. The distribution is taxed at your ordinary income tax rate, and in some cases, that could be a big check to cut. For instance, if you convert your $100,000 traditional IRA to a Roth IRA, you might owe $25,000 in federal taxes. Also, if you are under 59 ½ when making the conversion and you use a portion of your traditional IRA to pay the conversion taxes, penalties for early withdrawals could apply.
It makes the most sense to consider converting to a Roth IRA if: 1) you expect your income tax rates to be higher in the future – at the time you might otherwise draw out from a traditional IRA account, 2) you have some non-IRA cash available to pay the income taxes that would be due, 3) you have some time to grow the account before spending it for retirement (or don’t need to spend it at all for retirement) and 4) you don’t plan to leave all or a portion of your IRA to charity.
There are also lots of creative strategies to look at when considering a conversion to a Roth IRA. For example, you don’t have to convert your entire traditional IRA account all at once: you can segregate funds to convert the first year and convert another account the following year, etc. There is even a “do-over” provision in the tax law (called a “re-characterization”) that allows you to un-do a Roth conversion if it turns out to be not to your advantage – provided you meet certain deadlines to do this.
For every individual considering a move like this in 2010, there are plenty of questions and issues unique to your situation that must be addressed before you convert your traditional IRA to a Roth IRA. I highly recommend starting this discussion with your financial planner, but don’t do anything until you have your tax professional “sign off” on the strategy proposed. This is not a process for “do-it-yourself-ers!”
While the intricacies of a Roth conversion are many, the advantage of this tax change does offer investors, even in this dreary investment landscape, a true advantage in the quest to build and retain retirement capital, not to mention peace of mind for many retirees: simply not having to worry about whether income tax rates will increase in the future is priceless. It’s definitely an option to consider.
Karin Grablin, CPA, CFP®, MBA is with Dictor & Martin, Personal CFOs, Two N. Tamiami Trail #608, in Sarasota (906-7222) at www.dictormartin.com and is a registered representative & investment advisory representative with, and securities are offered through, LPL Financial, member FINRA, SIPC and a registered investment advisor. LPL and their representatives do not offer tax advice.
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Published in Sarasota Downtown & Beyond, November 2007