|New rules for Roth IRAs could apply
The Tax Increase Prevention and Reconciliation Act, passed by Congress earlier this year, changed a lot of financial regulations, but its most significant impact on upper-income earners may be the way it relaxes the rules regarding Roth IRA conversions. Starting in 2010, the income limits—which had prevented those with incomes over $100,000 from taking advantage of a Roth—will be eliminated.
That means this retirement planning tool is now open to nearly everyone. Professionals and small-business owners, who are more likely to rely on IRAs for retirement as opposed to 401(k)s, should consider whether it’s worth their while to convert their IRAs to Roths.
Changing the Tax Structure
|What’s the difference?|
The basic difference between a Roth and a regular IRA is this: the Roth IRA flips the tax advantage of a regular IRA on its head. While contributions to a regular IRA are tax deductible when they’re made, contributions to a Roth aren’t. But while savers must pay income tax on distributions from an IRA, distributions from a Roth are tax free as long as you’re over 59½ and have had the account for at least five years. This means that wealthier people, such as self-employed professionals who have depended on IRAs for their retirement plans, will be able to shift their tax burdens to now, when they can most afford it, and enjoy a relatively tax-free retirement.
But even though the income limits will be gone, that doesn’t mean a Roth will become right for everyone. If you convert your IRA, you will owe income tax on the amount converted (what you would have paid had you waited until retirement to take the money). So it makes sense to convert only if you have the assets to cover those taxes.
In fact, it’s best to make the conversion if you don’t need the money right away in retirement. Unlike a 401(k), there are no mandatory withdrawals from a Roth at age 70½. That opens up a whole new strategic level to a Roth, as you can wait until it is to your maximum tax benefit to begin your withdrawals.
In addition, it also makes more sense to convert to a Roth if you expect to have lower tax rates when you start making your withdrawals. If you expect your IRA to be your primary source of income in retirement, that makes it more advantageous than it would be if you have several other sources of income as well, keeping you in a higher tax bracket.
Another important caveat: while those people with incomes over $100,000 will be allowed to convert their IRAs to Roths, they won’t be allowed to make further contributions to them unless their incomes drop below that level.
Finding Your Way
It is a complicated situation, with many advantages for the savvy investor. The good news is that you have until 2010 to figure out all the ramifications. The other good news is that you can enlist a wealth manager to help you figure all that out. This is exactly the kind of intricate investment issue we deal with on a regular basis at Bernhardt Wealth Management.