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March: Plan for 2010 Roth Conversions

Starting in 2010, all taxpayers, regardless of the amount of their adjusted gross income (AGI), can convert a traditional individual retirement account (IRA) to a Roth IRA.  Before 2010, your AGI cannot exceed $100,000 to convert, not including any income resulting from the conversion.  Amounts converted must be included in income if taxable when withdrawn (i.e., contributions and earnings in deductible IRAs and earnings in nondeductible IRAs), but are exempt from the 10% early withdrawal penalty.   

If you make a conversion in 2010, the tax can be paid in two installments in 2011 and 2012, with no tax due in 2010.  However, if you prefer, you can elect to pay the tax in 2010, which may make sense if the current lower tax rates are not extended beyond 2010, or you expect much higher income in 2011 and 2012.  Taxes on conversions made after 2010 must be paid in the year of conversion.   

Even though this tax rule does not go into effect until 2010, you should start planning now.  For instance, you should consider making the maximum IRA contributions to a nondeductible IRA for 2007, 2008, and 2009, and then convert the nondeductible IRA to a Roth IRA in 2010.  The maximum IRA contribution is $4,000 for 2007 and $5,000 after that, plus an additional $1,000 catch-up contribution for taxpayers age 50 and older.  After 2008, the contribution amount will be adjusted for inflation in $500 increments.

By using this strategy, you would only have to pay income taxes on earnings within the IRA because the contributions are nondeductible.  However, be aware that if you also have other traditional deductible IRA funds, even in another IRA account, you cannot just convert the nondeductible IRA.  You have to assume that a pro-rata portion of both the deductible and nondeductible IRA funds are being converted.

Find out whether your 401(k) plan accepts rollovers from an IRA.  If it does, you could roll over your deductible IRA and earnings in your nondeductible IRA to your 401(k) plan.  You would then just have nondeductible contributions remaining in your IRA, which could be rolled over to a Roth IRA without paying any income taxes.  Check with your plan to see if you can later roll the funds back to an IRA.

This new conversion provision will effectively remove the income limitations for contributions to a Roth IRA after 2010.  For 2007, Roth IRA contributions can be made by single taxpayers with AGI less than $99,000 (contributions are phased out with AGI between $99,000 and $114,000) and by married couples filing jointly with AGI less than $156,000 (contributions are phased out with AGI between $156,000 and $166,000).  For 2008, Roth IRA contributions can be made by single taxpayers with AGI less than $101,000 (contributions are phased out with AGI between $101,000 and $116,000) and by married couples filing jointly with AGI less than $159,000 (contributions are phased out with AGI between $159,000 and $169,000).   It doesn’t matter whether you participate in a company-sponsored pension plan.  Starting in 2010, individuals with incomes over the limit can make contributions to a nondeductible traditional IRA and then immediately convert the balance to a Roth IRA.   

There are a variety of factors that should be considered before deciding whether to convert a traditional IRA to a Roth IRA.  Factors that favor converting to a Roth IRA include:

•     You can pay the income taxes due from the conversion with funds outside the IRA.  By doing so, you are in essence increasing your IRA’s value by the tax amount.

•     You expect your marginal tax rate at withdrawal to be equal to or greater than your current marginal tax rate.  When your rates are equal at both times, the financial results from either IRA will be similar.  Increasing income tax brackets generally makes it advantageous to convert to a Roth IRA.

•     You won’t make withdrawals from your Roth IRA for many years.  Estimates indicate that you generally need five to 10 years of tax-free compounding to compensate for the current payment of taxes.

•     You don’t expect to take withdrawals from your IRA.  Since you aren’t required to withdraw funds from a Roth IRA, even after age 70 1/2, your IRA balance can continue to grow on a tax-free basis.

•     You want to leave your IRA balance to heirs.  With a Roth IRA, your heirs receive the proceeds free of federal income taxes.  Also, if you don’t withdraw funds from the Roth IRA after age 70 1/2, you could potentially leave your heirs with a much larger balance than from a traditional IRA.   

Once the balance is converted, a qualified distribution cannot be made until after the five-tax-year holding period.  Distributions before then are subject to the 10% early withdrawal penalty, unless one of the exceptions applies.

Make sure that you are prepared to take advantage of the new Roth conversion rules in 2010.  Please call if you’d like to discuss Roth IRA conversions in more detail.   

 

 
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