Converting To A Roth IRA In 2010:
What You Need To Know

The rules surrounding conversions of traditional IRA money to a Roth IRA will change so that everyone will be eligible beginning January 2010. The change was signed into law by President Bush in May 2006 as part of a $70 billion tax cut. But, just because you can convert to a Roth IRA, does that mean you should? As a general rule, tax planners advise against paying a tax today that you can defer until a later date. Of course, there are always exceptions to any general rule, and converting to a Roth IRA may well be one of them.

With a Roth IRA, contributions are not tax-deductible, but earnings can be withdrawn income-tax-free if you're at least 59½ and have had the Roth at least five years. And you don't need to take required minimum distributions starting at age 70½, as you do with a traditional IRA.

Before the new regulation, a Roth IRA worked best when the person contributing to the account was in a lower tax bracket than what they expected to be in the future.  That way, the account holder would have tax free distributions from the Roth IRA during retirement, potentially keeping their retirement tax liability low.

But now, the Roth IRA could be appealing for a wider variety of savers. Higher-earning individuals will soon be able to convert to a Roth IRA. People who find themselves unemployed or making less – and are suddenly in a lower tax bracket – should also consider rolling over existing retirement accounts into a Roth IRA.

Income rules eliminated in 2010:
For 2009, the maximum contribution to a Roth IRA is $5,000. The full Roth contribution amount will be adjusted for inflation beginning with the 2010 Roth IRA contribution limits. Taxpayers over age 50 can make a $1,000 catch-up contribution to a Roth IRA, for a total maximum Roth contribution of $6,000.

The Roth IRA income limits for 2009 are $176,000 for married filing joint taxpayers, and $120,000 for single taxpayers. However, contributions to a Roth IRA are phased-out at lower income levels.  In order to make a full 2009 Roth IRA contribution, joint filing taxpayers must have a MAGI below $166,000. Taxpayers filing Single must have income below $105,000 to make a full Roth IRA contribution in 2009.

However, that’s going to change beginning in 2010 (and beyond) and those limitations will be abolished. In addition, there's a special rule in place for 2010 only that will allow you to recognize 100% of the conversion income in 2010 or split it equally between the next two tax years (2011 and 2012).

Even though you have to pay current income tax on the amount you convert to a Roth IRA, it still might make sense if:
1. You think you will be in the same or a higher tax bracket when you    withdraw.
2. You have a long time horizon (5 years or more).
3. You can pay the tax from sources other than your IRA, such as from regular taxable brokerage or bank accounts.
4. You don’t need to use the money and want to leave an income-tax-free Roth IRA to your heirs for gift and estate-planning purposes.

Spread the conversion tax over two years:
A new perk coming next year: deferred taxes. Those who convert to a Roth IRA in 2010 can spread their tax liability out across 2011 and 2012, thereby reducing some of the immediate tax hit. You will have the option to pay half the income tax in 2011 and the other half in 2012 at whatever tax bracket you are in during those years.

Tax considerations:
1. If you pay the tax from your IRA, you would lose the potential benefit of tax-free growth on that amount, defeating the purpose. Of course, if you’re under 59½, withdrawing money to pay the tax would be an even worse idea, since you would also incur a 10% federal penalty.
2. Ideally, you will have cash on hand to pay the income tax. If you need to sell appreciated assets to pay the conversion tax, the additional capital gains tax would work against the case for a Roth conversion.
3. Assuming you have the cash available elsewhere to pay the conversion tax, you still need to account for the “opportunity cost” of what that money could have earned had it remained invested in a taxable account.

Potentially higher tax rates:
All of those stimulus package initiatives and government bailouts are going to cost money. As a result, today's tax rates are probably the lowest you'll see for the rest of your life. The consensus is that taxes are more likely to rise – but no one knows how much.

If you are considering converting to a Roth IRA, you should get a move on, especially if you're young or the victim of a wage cut or layoff and are in the 10% or 15% tax bracket. In a year or two, you may be in a higher tax bracket because of a new job or salary increase, so it's best to take advantage of your low tax rates now.

Estate-planning benefits:
For those concerned about reaching their 80s or 90s with enough cash to leave to children, the Roth IRA offers some generous estate-planning benefits. Income taxes aside, very high net worth individuals may find that converting part or all of a traditional IRA to a Roth is advantageous for estate-planning purposes, especially if there is a significant IRA balance that doesn’t need to be tapped during the owner’s lifetime.

When a traditional IRA or 401(k) is passed on to a beneficiary, the beneficiary has to pay taxes on whatever is left in that nest egg based on their own tax bracket – not the tax bracket of the original account holder. With a Roth IRA, the beneficiary acquires the account without having to pay taxes on the cash that’s left. Thus, the income tax is paid at the time of conversion (preferably from assets other than the IRA) will reduce the owner’s gross estate. In effect, the account owner is prepaying income tax on behalf of future beneficiaries without it really counting as a taxable gift.

A Final Note:
Eligibility for a Roth conversion in 2010 doesn’t automatically make it a good idea. In fact, the very high-earning taxpayers who will become eligible for Roth conversion in 2010 are the least likely to benefit because they are already in the highest brackets. If a Roth conversion didn’t make sense for income tax purposes before 2010, it probably won’t afterward. Each situation needs to be evaluated on a case-by-case basis. Take a close look at your own situation and, if it makes sense, consider taking advantage of these rule changes. Also, be sure to talk with your accountant or other professional tax advisor about whether converting to a Roth makes sense for you.*

Please call our office at (925) 299-1500 or toll free (888) 299-1500 if you are interested in scheduling a review of your investment strategy and/or financial plan. If you are not a client of Capital Advantage, Inc., we offer free no obligation consultations.

*Information courtesy of Schwab Center for Financial Research

Prepare Now For Moves
On The Estate Tax