Roth IRAs open to wealthier Americans in 2010

Bill Hitchcock

Roth_IRA_BRoth IRAs open to wealthier Americans in 2010
By Eileen Ambrose
Baltimore Sun

Higher-income taxpayers for years have been shut out of the Roth individual retirement account and could only look on with envy.

But that’s about to change. Next year, everyone will have access – albeit, indirectly for some – to this tax-friendly account.

The government next year will eliminate an income cap for those who want to convert a traditional IRA, a 401(k) or other retirement account into a Roth. So, basically, anyone with one of these accounts can open a Roth. And in Maryland, the wealthiest state, this change in the tax law could be a boon for many.

“This conversion presents an opportunity we will look at for pretty much all our clients,” says Lyle Benson, president of the financial planning firm L.K. Benson & Co. in Towson.

There’s a lot to like about the Roth, which is more flexible than the traditional IRA.

Money goes into the Roth after you pay taxes on it, but when you make withdrawals in retirement, you won’t be taxed on any of the earnings.

So you never have to worry about tax rates going up. You also can pull out your contributions – though not earnings – at any time if necessary without paying taxes or penalties.

And you aren’t required to take distributions from a Roth after turning 70 1/2 , as you would with a regular IRA. This makes the Roth an attractive estate-planning tool for those who don’t need the Roth money to live on but want to leave it to heirs.

Still, as much as the Roth has going for it, investors need to carefully weigh whether they are better off converting to a Roth. Much depends on when you’ll need the money, on current and future tax rates, and on whether you have the resources to pay the tax bill that will come with a conversion.

“It’s a good thing for most, but it might not be good for everyone. So many factors come into play,” says Michael J. Agetstein, chair of the tax department for Katz-Abosch, a consulting firm in Timonium. “You can’t fit everybody into the same box.”

The Roth was created in the late 1990s and has always had income limits on who can directly contribute. That doesn’t change. Full or partial contributions to a Roth can be made this year if your adjusted gross income is less than $120,000 if single and $176,000 for married joint filers.

Next year, though, the $100,000 income cap disappears for anyone who wants to convert, say, a traditional IRA or an old 401(k) from a former employer to a Roth. (Some employers allow their older employees to convert a current 401(k) to a Roth, says Ed Slott, an IRA expert in Rockville Centre, New York. But you need to ask if your employer is one of them.)

Converting comes with tax consequences.

You will have to pay regular income tax on any untaxed dollars being converted to the Roth.

(If you have a mix of pre-tax and after-tax contributions to regular IRAs, the amount subject to tax in a conversion will be based on the percentage of untaxed dollars in all the IRAs – even if you aren’t converting all of them to a Roth. Say you have several IRAs and 80 percent of the total amount has never been taxed. Then 80 percent of the assets converted to the Roth will be subject to income tax.)

Uncle Sam offers some tax relief for conversions done next year only. You will have the option of paying half the tax bill on your 2011 tax return, and the rest on the 2012 return. You will pay tax, though, at whatever rates are in place in 2011 and 2012, so you could end up paying more if Congress raises taxes.

So, how do you know whether it’s worth taking a tax hit now so you can enjoy tax-free withdrawals from a Roth later in life?

A conversion makes sense for those who anticipate being in a higher tax bracket in retirement than they are today. Typically, that’s younger workers. Tax experts, though, predict that many of us will face higher tax rates in the future given the growing government debt.

Convert only if you have money from outside sources to pay the tax bill. You don’t want to pull money out of your traditional IRA, for instance, to pay the tax. Not only would you have less money to put into the Roth, but you would be hit with a 10 percent early withdrawal penalty if you’re younger than 59 1/2 . (You can always convert only a portion of the traditional IRA so the tax bill is something you can afford to pay with other resources.)

And convert if you don’t need to tap the Roth for living expenses in the near future. You want your investments to grow in the Roth as long as possible to make up for the tax hit you take upfront.

“The greatest benefit comes when you leave it there to grow,” says Bob Scharin, a senior tax analyst with Thomson Reuters’ Tax & Accounting business in New York.

Some experts suggest a Roth needs to be left untouched for at least 10 or 15 years to make a conversion worthwhile, although that depends on the investment returns and the tax rate, Scharin says.

Tax experts recommend converting to a Roth if you want to leave the money to heirs. The Roth would be subject to estate taxes, but heirs won’t have to pay income tax on the withdrawals, says KatzAbosch’s Agetstein. Plus, if you pay taxes upfront at the conversion, that reduces the size of your estate and the amount of estate taxes at your death, he says.

Not sure yet whether a conversion is for you? At troweprice.com, T. Rowe Price Associates offers an online conversion calculator to help weigh the consequences.

And even if you do convert, the decision isn’t final. You will have until mid-October of the following year to take back a conversion if you have regrets. That can happen, say, if the investments in the Roth plunge. By converting back to a regular IRA before the October deadline, you won’t have to pay taxes based on the original higher value.

“You get a second chance to do a do-over if it doesn’t work. It’s a no-risk transaction,” says IRA expert Slott.

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Author’s Yougler Profile is at  Bill Hitchcock.

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