2010 and the Roth IRA Conversion
Since it was created in 1997 by Congress, the Roth IRA has become a popular savings tool for those looking to save for retirement. Unfortunately, high income earners have been limited in their use of Roth IRAs due to maximum income limitations. However, due to recent IRS changes for the 2010 tax year, even high income earners will be able to utilize the Roth IRA by converting existing traditional IRA dollars to a Roth regardless of their modified adjusted gross income.
What is a Roth IRA? A Roth IRA is similar to a traditional IRA where current earnings on investments grow tax-free. The maximum contribution is $5,000 per year for both and if you are over age 50, the limit is $6,000. However, that’s where the similarities end.
Unlike a traditional IRA, the contribution to a Roth IRA is not tax deductible. Under prior year IRS regulations, a taxpayer filing jointly had to have modified adjusted gross income less than $167,000 to be eligible for a full Roth contribution ($105,000 for single filers). Eligibility was phased out when modified adjusted gross income reached $177,000 and $120,000 respectively.
Secondly, qualified withdrawals taken from a Roth IRA are not included in taxable income. To be qualified, withdrawals need to be taken after age 59 1/2 and only after they have been deposited for more than 5 years. If a withdrawal is non-qualified, the earnings portion of the withdrawal may be subject to a 10% withdrawal penalty and normal income taxes.
In addition, there is no required minimum distribution requirement at age 70 ½ for a Roth IRA, making it a useful estate planning tool as well. In basic terms, with a Roth IRA, investors have the ability to build substantial retirement savings that is considered tax-free for themselves or their heirs.
While it may sound like an easy choice, there are several items to consider before deciding to convert a traditional IRA to a Roth IRA. One such factor is whether the income tax rate you are subject to now will be higher or lower in the future. For someone who believes that their income tax rate will increase by their retirement age, it may make sense to convert to a Roth because of the tax savings in the future. Given the current economic and political climate, many economists believe that tax rates will have to go up in the future in order to fund government obligations, making Roth conversions an attractive alternative for many investors.
Time horizon and expected return will also play an important factor. If the future growth of the account exceeds the amount paid in taxes, the conversion becomes that more attractive. The longer the time horizon or the higher the expected return, the greater the chance that the earnings will exceed the amount paid in taxes due to compounding.
Finally, it is important that the taxes owed from a Roth conversion be paid with funds outside of the IRA. By doing so, the maximum amount of available funds enjoy tax-free growth. In addition, funds withdrawn to pay taxes prior to age 59 ½ will be subject to an additional 10% withdrawal penalty.
Under the 2010 conversion rules, the income attributed to the conversion can be spread over two years making the decision to convert more attractive. For conversions made in 2010, 50 percent of the income is claimed in 2011 and the other 50 percent in 2012, spreading out the tax burden. It can also give the tax payer some time to accumulate the funds to pay the extra taxes.
In summary, the Roth IRA offers substantial benefits for those investors who are able to utilize them. Congress has graciously made this product available to all taxpayers in 2010. It is prudent that each investor take the time to analyze whether converting to a Roth IRA is financially feasible before year end. We strongly suggest you consult with your tax preparer to make sure a Roth conversion is right for you.
For additional information about Roth IRAs, please call us at 504-835-1135. You may also visit our website at www.Crescent Sterling.com for other financial related articles.
Disclaimer: Please consult your tax advisor for determining the impact of tax related issues with Roth IRAs.