A Timely Consideration for Your Portfolio

Thirteen years after its inception, the Roth IRA is once again a conversation piece at the office water cooler and households around the country.  Not since the Tax Relief Act of 1997 has the Roth IRA been given more press.

In May of 2006, then President Bush signed a $70 billion tax cut provision that changed the eligibility rules for taxpayers who wished to convert traditional IRAs to Roth IRAs in 2010.  Now, taxpayers with income in excess of $100,000 are eligible to convert traditional IRAs and spread the tax liability over 2 years in 2011 and 2012.  In any conversion made after this year, the proceeds will have to be included as taxable income for the year the conversion is made.

Although the income limits on conversions have gone away, there are still income limits for those who wish to make contributions.  Single taxpayers who earn in excess of $110,000 and married taxpayers who earn in excess of $160,000 are precluded from contributing to the Roth IRA.  Upper income taxpayers who diligently try to minimize taxes may have had the foresight to begin funding non-deductible traditional IRAs back in 2006 when the new law was passed with the concept of converting whatever amount had accumulated in 2010.

Non-deductible contributions are made on an after-tax basis and will have no tax liability if converted to a Roth IRA.  The advantage to this strategy is that all earnings in the Roth will be tax free versus taxable earnings in the traditional IRA.  Kudos to those who took advantage of rising contribution limits on traditional IRAs with the prudence of future advantageous tax planning.

For those who still want to benefit from the new tax law, consider the following reasons for converting to a tax advantaged Roth IRA.

  • Many IRAs and qualified plans have depressed values from 2008 and 2009.  The current value will be converted and future growth will be tax free.
  • Old 401k’s with after tax money can be directly converted to a Roth IRA and owe income taxes on only the earnings from the after-tax contribution.
  • By converting to a Roth IRA, a taxpayer can reduce the size of his taxable estate allowing assets to pass to a beneficiary tax free (assuming the estate tax is re-enacted after 2010).
  • Government spending has many concerned that tax brackets will only increase.  Your current tax bracket may be at a historic low.
  • A re-characterization is allowed until October 15th of the year following the year you converted.  So, if for any reason you wish to convert back to a traditional IRA, you will have time to do so without adverse tax consequences.

Roth conversions offer many positive opportunities.  However, it is wise to consider all the following before making a decision.

  • The time you have until you will begin drawing on the funds.  The rules state you must hold the Roth IRA for five years until you can withdraw the funds tax free.
  • What is your tax bracket?  If your tax bracket is higher now than when you will withdraw the funds, it may not be prudent to pay taxes at a higher rate.  If your tax bracket is lower now than when you will withdraw the assets, conversion may make sense.
  • Can you pay the tax with non-IRA assets?  Yes, this will allow more of your money to grow tax free.  Using IRA conversion dollars only lowers the appeal of the conversion because you reduce the amount that will be able to grow tax free.  Also you would be subject to an additional 10{099636d13cf70efd8d812c6f6a5a855fb6f8f27f35bea282d2df1d5ae896e2c2} penalty by the IRS if you are under age 59 ½.

This tax season, you may hear many friends and colleagues discussing the pros and cons of the Roth IRA more so than in previous years.  A Roth conversion is a very personal matter that may have a significant financial result.  Please consult a professional tax advisor before making any decision regarding a conversion as each individual taxpayer is unique.