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To Roth or Not to Roth Your IRA

Based on client inquiries and recent conversations, the special rules for Roth IRA conversions in 2010 is a hot topic.  We'll share the FAQs and answers that we have addressed the past several weeks.

Should a Roth IRA be one of Your New Year Resolutions?
In less than a month, taxpayers with a traditional IRA funded with tax deductible contributions will face a major tax and financial decision.  While the rules are somewhat straight-forward, no "one size, fits all" answers exist.  Part of what makes the decision so difficult is the idea of paying tax now to ensure future tax-free income.  Here are some of the questions and answers we have handled the past several weeks:

What is a Roth IRA?
Roth IRAs are named for their legislative sponsor, the late Senator William Roth of Delaware, and have been part of the tax code since 1997.  Unlike traditional IRAs, contributions to Roth IRAs are not deductible and qualifying withdrawals are non-taxable.  Another attractive feature of Roth IRAs is that they are exempt from the minimum distribution rules that apply to most retirement plan account holders when they turn age 70 1/2.  In addition, there is no age limitation on making contributions, although there are income limitations that preclude high-income taxpayers from participating.

How do the "conversion" rules work?
From the time Roth IRAs were enacted, a lot of ink and attention has been paid to the opportunity to convert traditional IRAs to Roth IRAs.  In the year of conversion, the account owner has to recognize the IRA account value at the conversion date as taxable income and pay the additional tax triggered by the conversion.  Once this "toll charge" is paid, the account owner (and beneficiaries) will not pay tax on future, qualifying withdrawals.  Up until 2010, the ability to make a conversion was limited to taxpayers whose adjusted gross income (AGI) did not exceed $100,000.

So what is special about conversions in 2010?
Two special provisions make conversions in 2010 very intriguing.  First, the $100,000 AGI limitation is eliminated, which means everyone with a traditional IRA can undertake a conversion.  Second, the income generated by the conversion in 2010 (and only in 2010) can be deferred 50% to 2011 and 50% to 2012.

Shouldn't everyone take advantage of these rules?
  • It depends.  While everyone's situation is unique, there are several rules of thumb that seem indicative of considering a conversion:
  • You have sufficient cash in non-retirement accounts to pay the tax.
  • You believe tax rates in the future (when you would be taking withdrawals) will be higher than the rate you are paying now.
  • You won't need to make withdrawals anytime soon, which will allow you to earn back, on a tax-free basis, the tax you paid on the conversion.
  • You are comfortable paying tax currently, for the opportunity to generate a tax-free legacy for you and your heirs.

What's the catch?
Unless Congress takes action, the top tax rate is scheduled to increase from 35% to 39.6% for 2011 and future years.  In addition, some congressional health reform proposals contain an additional surcharge on higher-income taxpayers.  For this reason, taxpayers with extremely large IRA balances should tread carefully.

Final thought
One interesting aspect of converting to a Roth IRA is the opportunity to change your mind.  Taxpayers who undertake a conversion can change their minds up until the time the tax return for the year of conversion is due.  For example, if a taxpayer converts to a Roth IRA in January 2010 and extends the filing deadline for their 2010 Form 1040, that taxpayer has until October 15, 2011 to change his or her mind and restore the account back to a traditional IRA.

Why would someone want to change their mind?  Shouldn't they think it through and get it right the first time?
One good reason might be a post-conversion decline in investments like we have witnessed the past 18 months.  If something like that were to reoccur in 2010, undoing the original conversion and converting a second time would result in a lower amount of taxable income.  Another reason could be clarity in tax policy as Congress likely enacts new tax rates sometime during 2010 or 2011.

Bottom line - seek professional guidance and advice
In addition to Roth IRA conversions, another hot topic is capital gain planning in light of the soon-to-disappear 15% maximum tax rate.  Whatever your tax hot button, we are here to help, advise and share perspectives.  Give us a call.

We want to thank the nearly 150 folks who attended our Open House several weeks ago.  It was a great way to break-in the new offices and honor Stevie and Del Benkendorf for their 40 years of contributions to the Loveland community. 

On behalf of Brooke, Del, Ingrid, Lou and Teresa, best wishes to everyone for a safe and meaningful holiday season.  We look forward to seeing you next year.

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762 W Eisenhower Blvd
Loveland, Colorado 80537

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