New twists on Roth IRAs

Income restrictions on conversions will disappear next year, and you’ll be able to spread taxes over a two-year period. Will a Roth IRA conversion make sense for you in 2010?

If the income limits on Roth IRAs have kept these tax-free retirement savings accounts off limits to you, take heart. Next year, you’ll be able to roll your traditional IRA into a Roth IRA regardless of your income.

Why would you want to do that? Because withdrawals from Roth IRAs are exempt from income tax, provided you’re at least age 59½ and have had the account for five years (see IRS Publication 590 for full rules and exceptions). With traditional IRAs and other retirement plans, such as non-Roth 401(k)s, tax is deferred until money is withdrawn.

No withdrawals required

What’s more, you don’t have to take withdrawals from a Roth IRA, no matter how long you live. With other retirement plans, you generally have to take—and pay tax on—required minimum distributions after age 70½. (Those rules were suspended for 2009 after the stock market plunge.) Because of that, Roth IRAs work especially well if you have sufficient retirement income from other sources and want to leave a tax-free legacy to your heirs. Your beneficiaries might have to take required distributions, but they’ll owe no income tax if the account has been established for five years.

The catch is that you get no tax break for putting money into a Roth IRA, unlike tax-deferred plans. “With a traditional IRA or 401(k), you get instant gratification by saving tax initially,” says Eva Rosenberg, an enrolled agent in Northridge, Calif., and founder of TaxMama.com. “But you might owe income tax later on a much larger retirement fund.”

In the past, eligibility requirements limited access to Roth IRAs. In 2009, for example, workers and spouses can contribute up to $5,000 apiece, or $6,000 for those 50 or older by year-end. But single taxpayers are shut out if their modified adjusted gross income (MAGI) is over $120,000 this year; for married couples filing jointly, the limit is $176,000. (Partial contributions are permitted with MAGI over $105,000 or $166,000, respectively.)

You can also open a Roth IRA by converting a traditional IRA, a SEP-IRA, or a SIMPLE IRA to the Roth version. Here, though, the income limits are even stricter: Conversions are not allowed if your MAGI is over $100,000 this year on a single or joint tax return. That will change next year when the MAGI limit on Roth IRA conversions will be abolished.

If you don’t have an IRA but want to take advantage of that change, you can set up a traditional IRA and make a contribution for 2009 and another after Jan. 1 for 2010. If you’re not eligible to deduct those contributions because your income is too high, you can make nondeductible contributions to establish the account. You can then convert the account to a Roth IRA under the new eligibility rules. You’ll owe tax only on the earnings in the account if your contributions were made with after-tax money.

Converting larger accounts funded with tax-deductible contributions presents more of a challenge because you have to pay that deferred income tax when you move money to a Roth IRA. Typically, the tax would be due in the year of the conversion. For 2010, though, there is a one-yearonly tax break—you can defer the taxable income until 2011 and 2012.

Jumping the tax hurdle

Say you’re 60 years old and you have $400,000 in a traditional IRA, which you accumulated in a 401(k) plan and rolled over into an IRA. If you convert the entire balance to a Roth IRA in 2010, you would recognize $400,000 of ordinary income. Assuming an effective tax rate of 40 percent (state and federal), you would owe $160,000 in tax. But under the tax break for 2010 conversions, you can recognize 50 percent of that income in 2011 and the rest in 2012. So you can start earning tax-free income in the Roth IRA in January 2010 and not have to pay the full tax bill until early 2013, when you pay your 2012 taxes.

A potential downside, says Ingrid John, a CPA and director at Capital Management Group in Washington, D.C., is that you’ll owe tax at the effective tax rates in 2011 and 2012. “These rates could be higher than the 2010 rates,” she notes.

Ideally, you should pay the income tax from non-IRA funds. Using the example above, if you pay the $160,000 tax bill from the IRA funds, you’d have only $240,000 left to earn tax-free income in the Roth. But finding sufficient funds from non- IRA sources to pay the tax bill will be difficult if not impossible for many people.

One possibility is to do a partial conversion. Still using the example above, suppose you can afford to pay $50,000 in tax from non-IRA funds, even with the tax deferral to 2011 and 2012. You could convert $125,000 in 2010 and report half of that income ($62,500) in 2011 and another $62,500 in 2012. In future years, you could convert more of the traditional IRA to the Roth IRA. Meanwhile, the fiveyear clock for tax-free withdrawals starts on Jan. 1, 2010.

Sooner or later?

With these ground rules, should you do a Roth IRA conversion in 2010? “That depends largely on your current tax bracket and your expectations of future tax rates,” says Ed Slott, a CPA and IRA expert in Rockville Centre, N.Y.

Suppose you’re in your late 50s and earn a substantial income. You intend to retire in about five years and move from New York to Florida. With reduced income and moving to a state without an income tax, your tax bracket is likely to fall sharply. In that situation, a Roth IRA conversion probably doesn’t make sense. Why pay tax in the next few years, at your high rate, when you could take money from your traditional IRA at lower rates once you retire?

If you’re just starting your career and have a relatively low income and ample tax deductions for mortgage interest, you’re probably in a low tax bracket. You can convert your traditional IRA to a Roth without paying much tax. Once you meet the requirements, withdrawals from your Roth IRA would be tax-free, no matter how high income tax rates climb in the future.

Indeed, some people expect tax rates to rise as the federal government copes with budget deficits and shortfalls in Medicare and Social Security. “If that’s your concern, you may want to execute a Roth IRA conversion and pay tax,” Slott says.

The same logic applies if you think you’ll need little or no money from your IRA in retirement. You can convert your traditional IRA to a Roth IRA and keep the account intact for your beneficiaries.

This article appeared in Consumer Reports Money Adviser.