If you’ve considered converting your traditional Individual Retirement Account (IRA) to a Roth version, 2010 may be the most optimal time to do so. That’s because of new changes that take effect this year for the Roth IRA, as well as the slow recovery from the 2008 market crash.
Roth IRA Overview
Before we go there, here’s a brief overview of the Roth IRA. Because Roth contributions are not tax deductible, the Roth makes an ideal complement to an employer-sponsored retirement plan, since 401(k) participation precludes most IRA contributions from being tax deductible anyway.
In 2010, you may contribute up to $5,000 a year to a Roth ($6,000 if you are age 50 or older), but you may only contribute to a Roth if you earn less than:
* $177,000 and your filing status is married filing jointly or qualifying widow(er);
* $120,000 and your filing status is single, head of household, or married filing separately*
After you’ve owned your Roth IRA account for five years or more, you may take out money for certain qualified expenses without having to pay an early withdrawal penalty. Qualified expenses include for a first-time home purchase, qualifying medical expenses, health insurance premiums, or if you become disabled. After age 59½, you may withdraw funds from your Roth IRA for any reason.
Because it does not force you to take Requirement Minimum Distributions (RMD) at age 70½, the Roth is designed to accommodate today’s longer-working preretirees. After all, it’s silly to have to withdraw money while you’re still earning enough to live on. Unlike the traditional IRA, you may continue contributing to the Roth as long as you earn income, and you don’t have to withdraw from the account until you’re ready.
New Roth IRA Rules
When you convert a traditional IRA to a Roth, you are liable for federal income taxes on all previously non-taxed money, including all gains and any contributions made on a pre-tax basis. You may also convert an employer-sponsored 401(k) plan to a Roth IRA, subject to the same tax liability and conversion rules.
Rule changes passed in 2006 go into effect in 2010, allowing all investors to make the conversion regardless of income level. Previously, only account holders who earned less than $100,000 a year were allowed to convert to a Roth.
The market crash and subsequent slow recovery of the last two years has yet to return stock market performance to previous highs, so ensuing taxes on a conversion will still be relatively lower. Plus, thanks to the new rules that go into effect in 2010, you may split up your conversion taxes in 2011 (50%) and 2012 (50%). This tax benefit is applicable only to conversions completed in 2010.
The advantage to owning a Roth is that it allows you to diversify your tax burden. Basically, you pay some now and some later—after you retire. With traditional IRA and 401(k) plans, the strategy is to pay taxes later. But you have no control over how much you’ll be paying later—and given our growing national debt and the huge population of baby boomers that will rely on government benefits for seniors—taxes could be much higher once you retire.
The Roth IRA lets you pay some of that tax burden off today, before your investments accumulate earnings over time. By paying income taxes on contributions, you completely avoid taxation later.
Diversifying your tax strategies can help you avoid an excess burden later down the road, once you’ve stopped earning income and are drawing from your investments for retirement income.
While the 2006 Tax Reconciliation Bill eliminated the $100,000 income limit for conversions, it still restricts high-income earners from contributing outright to a Roth IRA.
However, the new rules do pretty much eliminate the income restriction on contributions as well. That’s because regardless of your income level, you may continue to open and contribute to a traditional IRA, then convert to a Roth when the timing is right. As a general rule, you may consider the timing to be right when Republicans maintain the majority in government legislation—when tax rates tend to be at their lowest.
If the past is any gauge of the future, then the trend is for bull markets follow bear markets. In fact, there have been 14 bull markets (defined as an increase of 20% or more in stock prices) since 1930.
Now may be a good time to convert a traditional IRA to a Roth, before stock prices rebound and create a higher tax liability on gains.