Always wanted a Roth IRA?

For nearly a decade, headlines ranging from “Roth IRA: the Smartest Money Move a Young Person Can Make” to “Roth IRA Shines as an Estate Planning Tool” have promoted the diverse benefits of this investment option. The advantages of a Roth, where after-tax dollars grow tax-deferred and are distributed tax-free, are obvious. However, the Roth’s income limits likely have prevented many from opening an account. In 2008, for example, only those married filers with modified adjusted gross income (MAGI) below $169,000 ($116,000 for single filers) can deposit money into a self-directed Roth IRA. Even then, the maximum contribution is $5,000, or $6,000 for those over age 50. The rules that govern the conversion of traditional IRAs to Roth IRAs are even more limiting. Taxpayers must have MAGI, individual or joint, of under $100,000 to roll over a traditional IRA directly to a Roth IRA. However, that $100,000 income cap is scheduled to disappear in 2010, courtesy of the Tax Increase Prevention and Reconciliation Act of 2006. Although seemingly “too good to be true,” after 2010 you can convert your traditional IRA to a Roth IRA, regardless of your income or filing status.

Why convert to a Roth IRA? In a word: diversification. Traditional wisdom has held that the best way to save for retirement is to stash pre-tax dollars in a 401(k), watch your account grow tax-deferred, and pay the taxes in retirement when you are in a lower tax bracket. However, our historically low tax rates and high national debt create the real possibility that you may be in a higher tax bracket come retirement. Because you cannot predict your retirement income or what will happen to the tax code, diversifying between taxable and nontaxable retirement savings accounts seems prudent. Another plus is that Roths do not require a distribution to begin at age 70½, as you must with traditional IRAs and other tax-deferred investment vehicles. Because you are not even required to take distributions from your Roth during your lifetime, your heirs may benefit from decades more of tax-free growth.

Converting assets to a Roth in 2010 will not trigger the 10-percent pre-59½ withdrawal penalty; however, you will need to pay income taxes on the converted amounts. Accordingly, if you plan to take advantage of the lifting of income restrictions, it may make sense to begin setting money aside now to pay those inevitable taxes. Remember, you won’t want to withdraw money from other IRAs or your 401(k) account to pay the income taxes for your conversion because you’ll be assessed the 10-percent penalty if you are under age 59½. However, if you choose to convert a regular IRA to a Roth in 2010, you can spread your ensuing tax bill over 2011 and 2012.

If you can’t wait to get money into a Roth, you may have another option. Although your income may prevent you from opening a Roth IRA, you’re in luck if you work for one of the 22 percent of employers that the Profit Sharing/401(k) Council of America (PSCA) says offer Roth 401(k) retirement plans to employees. All plan participants, regardless of adjusted gross income can choose to make Roth 401(k) contributions. Furthermore, it is possible to divide your contributions between a regular 401(k) and the Roth 401(k). However, if your employer matches your contributions, those funds will be placed in a regular 401(k) plan, because they are tax-deductible for your employer. This means that even if you put 100% of your contributions into the Roth 401(k), you also will have assets in your 401(k) plan that will be taxed upon withdrawal.

If your employer doesn’t currently offer the Roth 401(k), that may be about to change. According to the 2007 PSCA Survey, 69 percent of companies that currently do not offer the Roth 401(k) said they likely will offer this option in the future. The delay in offering it is not due to your employer’s red tape, but to their healthy caution. You see, it wasn’t until the Pension Protection Act (PPA) of 2006 passed that the law authorizing Roth 401(k)s was made permanent. Naturally, the previous sunset provision raised questions about whether employees who made Roth contributions would ever be able to satisfy the law’s five-year holding period requirement necessary for tax-free withdrawals.

Employers’ wider acceptance of the Roth 401(k), as well as the termination of the $100,000 income cap for Roth conversions, may be the catalyst needed to move the Roth IRA into the limelight where it belongs. Interestingly, although the Roth IRA celebrates its 10th anniversary this year, it’s still underused compared to traditional IRAs. According to a May 2008 report, Ownership of Individual Retirement Accounts (IRAs) and 401(k)-Type Plans,” published by the Employee Benefit Research Institute (EBRI), of the $2.5 trillion invested in IRAs in 2002, 92% (or $2.3 trillion) went to traditional IRAs. Roth IRA investments amounted to $77.6 billion, and other IRAs attracted $133.4 billion in 2002. Thus, Roth IRAs accounted for just over 3 percent of all IRA assets in 2002.

However, EBRI also found evidence that the Roth may be making its move. Specifically, of the $42.3 billion in new IRA contributions in 2002, only $12.4 billion, or 29.3 percent, went to traditional IRAs, both deductible and nondeductible. Roth contributions represented 31.2 percent of contributions, while the share of other IRA contributions was 39.5 percent.

Naturally, you need to take care in making rollovers from qualified plans to avoid any unintended tax consequences. If you’re considering a Roth conversion, please contact us for additional information and guidance.

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