Most of us dread the thought of the ever-changing tax laws. This time around you may be lucky enough to benefit from the already established changes. Beginning in 2010, new tax rules offer the unique opportunity for previously excluded, higher-income individuals to establish a Roth IRA. Here is what the changes mean to you:
What are the current rules?
Taxpayers with a MAGI (modified adjusted gross income) of $100,000 or less in the year of con-version are eligible to process a Roth IRA conversion. Taxpayers who are married but file a sepa-rate tax return are not eligible for Roth IRA conversions. When determining eligibility the amount of conversion is not included in the $100,000 MAGI limit. The conversion, however, will be taxed as ordinary income.
How will the rules change after January 1, 2010?
Beginning in 2010 the current MAGI limit and filing status restrictions will be removed.
Who will be eligible to convert a traditional IRA to a Roth IRA?
As of January 1, 2010 anyone with a traditional IRA will be eligible to convert their IRA into a Roth IRA. The normal 10% tax penalty for traditional IRA distributions prior to the account owner at-taining age 59 ½ will not be assessed for a Roth IRA conversion.
Will I be taxed on the conversion?
The entire Roth IRA conversion amount will be considered taxable income. The IRS will allow you to spread the tax payments over two years—2011 and 2012. You may also choose to withhold for income taxes at the time of conversion. Please work closely with your CPA or tax professional to determine the best tax strategy for your situation.
How is a Roth IRA different from a traditional IRA?
A traditional IRA is characterized by deductible contributions that grow tax deferred until distribu-tion. When distributions are made from a traditional IRA they are considered ordinary income. Contributions to a Roth IRA are not deductible. Roth IRA contributions grow tax free because they are not taxed within the Roth IRA or at the time of distribution (as long as the minimum hold-ing period, usually five years from time of contribution, and other requirements, such as age, are met). Distributions from Roth IRA earnings that have not satisfied the IRS requirements are sub-ject to income tax and in certain situations an additional 10% tax penalty may apply.
What are the disadvantages and benefits of the Roth conversion?
While there are a lot of benefits to convert to a Roth IRA, there are a few disadvantages you should consider before making a decision. First, if you are under 59 ½ you must use cash (outside of your IRA) to pay for your income tax liability. If you do not have the cash available the withholding (if taken from an IRA) may be subject to an additional 10% tax penalty. Next, if you believe your effective tax rate will decrease between the present and when you will begin distrib-uting your IRA you may want to reconsider – in this situation the traditional IRA may be more beneficial.
In contrast, there are various benefits available if you decide to do a Roth conversion. Obviously, tax free withdrawals are one of the main attractions to Roth IRAs. Conversions also offer signifi-cant tax advantages with estate planning. Converting all or a portion of your traditional IRA to a Roth IRA will reduce your taxable estate without a reduction in the tax-free earnings and distribu-tions that can be transferred to your beneficiaries. Last, there is no required minimum distribu-tion for Roth IRAs allowing you to leave your money invested for as long as you want.
Who should convert to a Roth IRA?
Since there is no easy formula or rule of thumb individual analysis is required. Many factors must be considered including age, health, net worth, retirement goals, tax planning, estate and income taxes. It is important to discuss your options and determine the amount, if any, would be most beneficial to convert to a Roth IRA.
How do I get started?
If you are interested in the possibility of a Roth IRA conversion in 2010 please call your Financial Advisor in December 2009 or January 2010 to get the process started.
Charles C. Zhang, CFP®, ChFC, MBA, MSFS
Zhang Financial
Portage, MI