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The new tax break has been called the single best gift that Congress has presented to the tax payer for 2010 (and potentially beyond). Some have called it a great estate building and wealth transfer tool. What is the ‘buzz’ in the financial community about? What is so great about the new tax law that will go into effect in 2010? After all, the Roth IRA was first introduced in 1997. However, on its introduction in 1997, the law limited the benefit to certain people. Contributions to the Roth could only be made by people with income of less than approximately $ 160,000 if filing jointly or less than $ 95000 if filing as a single. Secondly, under the current law, with regard to conversions, one could convert IRA’s to Roth IRAs if the Adjusted Gross Income was $ 100,000 or less. In 2010, the law changes and the income limitation has been removed for conversions! So it does not matter whether one is making $ 10,000 or $ 1,000,000 in income, starting in 2010 one can convert IRAs to Roth IRA! Starting in 2010, one can also convert their funds in SEP IRAs, SIMPLE, 401Ks and other pension or profit sharing plans into Roth IRAs. (as long as you follow the rules pertaining to those specific plans) So if you have accumulated $ 50,000 in the IRA, you could easily convert the amount to the Roth. It is almost as though you could make unlimited contributions to Roth, as long as you have accumulated the funds in the IRA or any qualified account! Remember that on these conversions, ordinary income taxes are due on the converted amount. The biggest hurdle for anyone to cross in making very large conversions is the payment of income taxes at current tax rates. Congress has included an additional break in the payment of taxes. For any conversions in 2010, the taxes can be paid over two years in 2011 and 2012 at rates applicable in those years!

Going back to the basics, in a Roth IRA, you are investing ‘after tax ‘dollars or you have already paid taxes on the money invested in the Roth IRA account. As the earnings accumulate and the account potentially grows, you do not have to pay taxes. No taxes are due on qualified withdrawals either, such as withdrawing the money after age 59 1/2 that has been held in the account at least 5 years. Therefore, you are paying taxes on the ‘seed’ and not on the ‘harvest’. In a Traditional IRA on the other hand, you are investing ‘pre-tax’ dollars or you can get an income tax deduction on the money invested. As the earnings accumulate in this account, there is no tax. However, taxes at ordinary income tax rates are due on the withdrawals. So in a sense, you do not pay taxes on the ‘seed’ but pay taxes on the ‘harvest’. Withdrawals prior to age 59 1/2 are subject to IRS penalty.

I hear the comment from people all the time that “at retirement, I will be in a lower tax bracket, so wouldn’t the IRA be the best vehicle for retirement” This brings us to the crux of the discussion. One has to make the determination, in fact an assumption based on one’s own personal circumstances whether one will be in a higher or lower tax bracket at the time withdrawals are made from the account. To make this determination, I illustrate with a simple example. Suppose you are living on $ 5000 a month in living expenses today. In 18 years, at a 4 % inflation rate, you will need $ 10,000 a month to live. Would the taxes on an income of $120,000 a year be more than taxes on an income of $ 60,000 a year? If the answer to this question based on the assumption that current tax laws will continue to be the same, is ‘more taxes’, then the Roth IRA is the better option for longer-term retirement income.

What are other considerations for converting the IRA to Roth IRA starting in 2010?

  1. It may make be better to pay taxes on the Roth conversions from outside funds than from the IRA itself. In effect, by paying taxes with outside after-tax funds, you are ‘grossing up’ the Roth IRA. In other words, the ‘tax’ dollars remain in a tax-free status in the Roth. Furthermore, if you withhold money to pay taxes prior to age 59 1/2, the amount is subject to a 10% IRS penalty.
  2. Hedging against future tax increases and to implement tax diversification strategy.
  3. Capitalizing the present market ‘low-cost’ situation, to capture tax-free future growth.
  4. For Wealth Transfer and Trust planning purposes, the Roth IRA may make more sense.
  5. Minimization on the impact of Social security taxation.

While there may be many reasons to convert, a major reason not to convert is the payment of immediate taxes. Secondly if you have to make withdrawals for retirement income in the next 10 to 15 years, there may not be a reason to convert that amount of money used for withdrawals. Therefore one has to evaluate one’s own situation, particularly with regard to taxes and come to an appropriate decision. As the tax laws are complex and the nuances are many, please consult a qualified financial or tax advisor regarding your specific situation. Tax laws can change and can impact benefits of the Roth. Restriction and limitations generally apply for retirement accounts.

Jay Kabad, CFP®, is President of Jaykay Wealth Advisors, Inc, a Houston-based wealth management firm. He received his Graduate degree from IIT Madras and an MBA from University of Pittsburgh, PA in 1980 and has been in business for 27 years. He is a Financial Advisor with LPL Financial and can be contacted at 713-780-4575. Securities and investment advisory services are offered through LPL Financial, Member FINRA/SIPC. The opinions voiced in this material are for general information only.