While you may not be able to solve the nation's economic problems, this year you can begin solving a few of your own. If you have struggled to save and invest money toward your retirement, a new law that went into effect January 1 could give you a new way to work toward that goal. According to a FINRA National Financial Capability Study 58% of all Americans don't even know how much they need to save for retirement and just slightly less (51%) have a retirement plan at work; only 28% maintain a personal retirement account outside their employer-sponsored plan.
Roth IRAs can be a valuable retirement investment tool. They were created as part of the Taxpayer Relief Act of 1997. Roth IRAs are tax-sheltered investment retirement accounts that provide income-eligible people with a way of building tax-deferred retirement income. Unlike traditional IRAs that allow tax-deductible contributions, you can only contribute to a Roth IRA with after-tax income; however you will not have to pay taxes when you take distributions from your account upon retirement, unlike the traditional IRA.
Roth IRAs also have the added benefit of not requiring holders to take an annual minimum required distribution. At age 70.5 conventional IRA holders have to withdraw a minimum amount each year and pay taxes on that amount.
Difference Between Traditional IRAs and Roth IRAs
|Traditional IRA||Roth IRA|
|Age Limit On Contributions||Cannot contribute after age 70.5||Can contribute at any age|
|Income Limit On Opening And Funding Account||No income limit||Income limits on high-income earners*|
|Tax Deduction For Contributions||Most are made pre-tax||Contributions cannot be made pre-tax|
|Tax On Distribution/Withdrawal||Tax-deferred portion of distribution is taxed||No tax|
|Mandatory Required Distribution (MRD)||Must take minimum withdrawal annually beginning the year you turn 70 ½||No MRD|
|*Single taxpayers phase out between $105,000-$120,000; married couples filing jointly phase out between $167,000-$177,000|
A new law has made it possible for people who were previously unable to benefit from a Roth IRA to do so, and limits the one-year tax impact. As of January 1, the federal government lifted the income cap on people seeking to convert their traditional IRA account balances to a Roth IRA and provided a tax break to people who choose to convert all or a portion of their traditional IRA to a Roth IRA in 2010.
However, the income limits are still in place so while everyone is now eligible to convert traditional IRA account funds to a Roth IRA, people earning over the income limit may not open and fund a new IRA. (Learn about the benefits and drawbacks of this new investment account in A Closer Look At The Roth 401(k).)
Since the investment tool's invention, an income limit prevented high-income earners from two major Roth IRA benefits. First, singles earning more than $120,000 and married couples jointly earning $176,000 or more were not allowed to open and fund a Roth IRA.
In addition, people with adjusted gross incomes (AGIs) of more than $100,000 were not allowed to convert their traditional IRAs to Roth IRAs. When converting from a traditional IRA to a Roth IRA you are required to pay federal income taxes on both the earnings you accrue on the investment and on the pre-tax deposits you made to the account.
However, in May 2006 President Bush changed the eligibility rules for Roth IRA contributions and conversions; those changes took effect January 1, 2010 and will continue into the foreseeable future (or until Congress acts to make a change). Now anyone, regardless of income, can convert their traditional IRA to a Roth IRA.
In addition, if you convert your traditional IRA savings to a Roth IRA this year you can take longer to pay the taxes on the amount you roll over. That's because the IRS is allowing you to defer full payment - you can either pay the tax due in 2011 or split the income you earn on the conversion and pay half the tax due in 2011 and the remaining half in 2012.
Taxpayers who have significant portfolio losses may be able to offset the tax impact incurred by converting to a Roth IRA. (Learn the requirements for withdrawing funds tax and penalty free in Tax Treatment Of Roth IRA Distributions.)
The Bottom Line
Before making your selection calculate how a conversion would impact your total tax bill, and talk with your financial advisor and/or tax professional to determine if converting all or a portion of your conventional IRA to a Roth IRA makes the best financial sense for your situation.