ROTH IRAS | NEW TAX ADVANTAGES? by Beth Jones, RLP®
Does it seem that retirement savings rules are a moving target? With rules for Roth IRAs changing in 2010, it may be to your advantage to convert from a pay-later to a pay-now vehicle.
Historically, retirees have relied on three different sources to meet their retirement income needs:
- Social security
- Personal savings (including IRAs, retirement plans, investments and savings)
- Pension plans
Increasingly, however, Americans have to rely upon their own personal savings to fund their retirement as employers have discontinued their pension plans, shifting the responsibility for saving to individual employees. Increased life expectancy has contributed to an overburdened social security system.
TRADITIONAL VS. ROTH IRAS
Traditional and/or Roth IRAs can be an effective investment vehicle for retirement savings due to their favorable tax status and flexibility of investment choices. Traditional IRAs allow for pretax dollar contributions (i.e., pay taxes later; avoid them now); Roth IRAs allow for post-tax dollar contributions (i.e., pay taxes now; avoid them later). There are different rules regarding the funding, eligibility, and deductibility of Traditional and Roth IRAs.
THE NEW RULES
Through 2009, only individuals with adjusted gross incomes less than $100,000 are able to convert qualified dollars to a Roth IRA. Beginning January 1, 2010, however, the $100,000 limit will be eliminated, so individuals who were previously unable to convert to a Roth IRA will now be permitted to.
When you convert to a Roth, you pay income tax on the taxable dollars that are converted. One benefit of the new rules is that eligible individuals electing to convert in 2010 will be able to spread out the income tax payment in equal installments over two years. If they elect to defer taxes, they may pay 50 percent of the tax burden in 2011 and 50 percent in 2012. Taxes due from conversions after 2010 will be due in full in the year of conversion.
REASONS TO CONSIDER A ROTH CONVERSION
There are many benefits of converting to a Roth IRA, depending upon your situation. You should always consult with a financial professional to determine the best way to invest for your future and a qualified tax advisor to learn about applicable tax regulations and their impact on your investments.
TAX-FREE WITHDRAWALS — Retirement can span 20 years or more, so tax-free withdrawals have become an attractive feature. When you do a Roth conversion, you are paying taxes today in order to receive a qualified, tax-free distribution in the future. If you believe your income tax rate is likely to be higher in the future than it is today, consider setting up or converting to a Roth IRA.
You may take qualified tax-free distributions from a Roth IRA after you have had it for five years and when the distribution is for one of the following reasons:
- Age 59½ or older
- Death
- Disability
- First-time home purchase
NO REQUIRED MINIMUM DISTRIBUTION (RMD) — Unlike Traditional IRAs, Roth IRAs do not require that minimum distributions begin at age 70½. This allows those who do not need that income stream in retirement to pay the taxes now, keep all of the Roth IRA money invested beyond age 70½, and avoid the annual income tax burden that exists with RMDs.
HEDGE AGAINST RISING INCOME TAXES — Although no one has a crystal ball, it is conceivable that income tax rates will be higher in the future than they are today. Over the past several decades, only once during a five-year period has the top income tax rate been less than today’s current rate of 35 percent.
AN EFFECTIVE ESTATE PLANNING STRATEGY — Converting to a Roth may be an effective estate planning strategy if your goal is to preserve assets for your heirs. Distributions from a Roth IRA are not required until a non-spouse beneficiary inherits the accounts, so more assets can be preserved for future generations. Beneficiaries can generally stretch those distributions based on their life expectancy and the income is free from federal tax.
CONSIDERATIONS
There are many things to consider before making the conversion decision. A qualified professional can help you explore the following important questions:
- Do I expect tax rates to be higher or lower when I retire?
- Do I have a large percentage of assets in Traditional IRAs? If you have a concentration of assets in traditional IRAs, you may want to consider converting some of those assets as a way to hedge against future tax increases. Supplementing retirement with nontaxable income may increase the likelihood that you will be in a lower tax bracket during retirement.
- If I convert, can the conversion taxes be paid from a source outside of the IRA? Using IRA assets to cover the tax bill will typically result in more taxes being paid and may involve early withdrawal penalties, depending on your age, so it is generally better to pay the tax owed with funds from outside the retirement account.
- Will I need access to the money within five years? If you think you will need access to the assets within five years, then a Roth conversion may not be right for you at this time.
- Do I have retirement accounts that have suffered losses? If your account values are lower since the market downturn in 2008, then converting these accounts to a Roth IRA may result in a lower income tax.
It is wise to be aware of the changing regulatory environment and how it may impact your future retirement. If you need assistance consider consulting an independent Financial Consultant to ensure that you’ve considered all the possibilities; they typically take a more holistic approach.
Beth Jones, RLP® is a Registered Life Planner and Financial Consultant with Third Eye Associates, Ltd, a Registered Investment Adviser located at 38 Spring Lake Road in Red Hook, NY. She can be reached at 845-752-2216 or www.thirdeyeassociates.com. Securities offered through Commonwealth Financial Network, Member FINRA/SIPC.
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