Upcoming changes make it an attractive option for some investors
It’s not too early to prepare for 2010, when an important change in IRA regulations regarding Roth IRAs goes into effect for highincome investors.
Beginning in 2010, the $100,000 modified adjusted gross income limit, or MAGI, limiting conversion of funds from traditional IRAs to Roth IRAs, is waived. This presents an opportunity for thousands of investors whose income eliminated them from even considering a Roth conversion.
In addition, as an added incentive to convert in 2010, the taxable income resulting from a Roth conversion (in 2010 only) can be spread out over two tax years, 2010 (paid by April 15, 2010) and 2011 (paid by April 15, 2012.).
Why convert your IRA?
Why convert in the first place? Well, the advantages of a Roth IRA can be compelling. The Roth is funded with after-tax dollars, and all future growth can be withdrawn completely tax-free. This makes a Roth a superb home for your more growth-oriented investments, particularly those that still have some way to go to recover their previous value. If they recover in the Roth, the gain is tax-free.
Additionally, unlike a traditional IRA, a Roth is not subject to required minimum distributions at age 70 . A spousal beneficiary can take over a Roth IRA, make it theirs, and allow it to continue to grow. Only when a non-spousal beneficiary inherits the account are distributions required, and then only over the life expectancy of the beneficiary. The implications of having, say, a grandchild as a Roth beneficiary, can be staggering. Finally, a Roth IRA gives you a lifetime shelter from taxes, no matter how high the tax rates might rise in the future.
Factors to consider
A Roth conversion in 2010 is not necessarily the best strategy, even if your income has precluded you from considering a Roth rollover in the past. First, consider your present and future tax bracket. If you think your tax bracket will fall significantly, you may be better off leaving your IRA alone and paying the taxes on the money as you withdraw it.
Second, how will you pay the additional conversion-related tax? A conversion probably won’t make sense unless you have money outside your IRAs to pay the tax bill. If you withdraw from the IRA to pay the tax on the withdrawals, they may be subject to a 10 percent penalty if you’re under 59 1/2.
Time is also an important factor. In general, the longer you have until you plan to withdraw your earnings tax-free from the Roth, the better the numbers will look.
Remember, the additional income resulting from a Roth conversion may increase the taxable portion of your Social Security, and may lower or eliminate your ability to take certain income-related itemized deductions as well. When evaluating the benefits, be sure to include the present value of the funds you use to pay the taxes on conversion; you would have had this money and all its growth if you didn’t convert.
There can be estate tax advantages to a Roth conversion as well. When you pay the conversion tax, you effectively prepay income taxes for your heirs without owing any gift tax or using up any of your valuable estate-tax exemption ($3.5 million for 2009). Prepaying the income taxes reduces the size of your taxable estate.
Preparing for 2010
You can get started by doing some necessary research on your IRAs and eligible 401(k)s. Be sure to identify any accounts that have both pre-tax and after-tax money. Examine strategies to reduce taxable income as much as possible in the year of conversion, or 2010. It may make sense for some investors, especially those who have had their required minimum distributions, or RMDs, waived in 2009, to take out additional funds and plan to spend them in 2010 to lower that year’s taxable income. Remember, the waiver of required minimum distributions is for one year only, and you cannot convert your RMD to a Roth, even in 2010. We recommend that you have a pro-forma tax projection done for 2010 and 2011, based upon your last tax filing, so you see the total tax implication of the conversion. Spend some time with your CPA or tax advisor on the numbers.
Steven Weber, registered investment advisor, and Gloria Harris, director of Client Communications, are members of the Bedminster Group, a feeonly advisor providing investment and fi nancial counsel to clients in the Lowcountry since 1997. The information contained herein was obtained from sources considered reliable. Their accuracy cannot be guaranteed. Furthermore, the opinions expressed are solely those of the authors and do not necessarily refl ect those from any other source.