With government revenues low and spending high, it's no wonder that new tax rules have emerged. The new Roth IRA rules may be one of the few tax changes that provide a win-win opportunity for both investors and the government - here's how. (Learn the requirements for withdrawing funds tax and penalty free, in Tax Treatment Of Roth IRA Distributions.)

Versus the Existing Rules
The Roth IRA is limited in two ways, under the existing (2009) tax rules. First, those with high incomes aren't allowed to contribute to an Roth IRA. Second, those with high income aren't allowed to covert a traditional IRA into a Roth IRA. It's the latter that is changing, and provides the new opportunity.

The 2009 rules restrict conversions from a traditional IRA to a Roth IRA. If you have a modified adjusted gross income (AGI) of $120,000 or more, you aren't allowed to covert, nor are you allowed to covert if you are married and filing a separate return.

The 2010 rules remove these restrictions, and if you earn more than $120,000 in income, this may be an opportunity. If less, this change is moot, but you still may want to look at converting your traditional IRA to a Roth IRA.

Paying the Taxman
But converting means you need to pay taxes on the existing IRA account when you convert it. This benefits the government as it increases the tax revenue now, instead waiting until you withdraw the money when you retire years from now. Remember, traditional IRAs grow tax-free, but withdrawals are taxed. Roth IRAs grow from deposits, but withdrawals are tax free.

This begs the question, "Should you convert and pay the taxes now?" The answer, which is typical to most financial planning questions, is "It depends."

The most important consideration, and the one that will likely trip up the most people, is having enough money to pay the taxes now. If you have rolled over a 401(k) into your traditional IRA and have been making solid contributions over the years, it's possible you have decent nest egg at this point. The conversation will move this into gross income for the year you convert, and you'll have to pay taxes on it as if you earned the money. That can be quite a bill. What is probably a very poor strategy is to pay that tax bill using your IRA funds.

IRS To the Rescue!
However, there is some help from the IRS in 2010, as there's a special rule to split the conversion equally between the following two tax years (2011 and 2012). This is a reasonable alternative to paying them now. However, if your tax rate goes up in those years, you may be paying more. Additionally, if you are planning on paying with income and you lose your job, the bill will still be due.

If you have the funds to pay the taxes, either in 2010 or spread over the next two years, there still is the question of it being a good idea for you, personally.

Some Things to Consider
Will you have lower income in 2010, and therefore paying at a lower tax rate than is typical? If you believe you will have higher (or equal) tax rates in the future during distribution, then tax-free distributions will be beneficial. If you want to leave an estate for others, the Roth has no minimum distribution requirements and it can be passed on to children or grandchildren (tax free), where it can continue to grow until they retire. If generational wealth transfer, or reducing estate taxes, is something that is important to you, this is something you should strongly consider.

By paying the taxes, you lose the opportunity to earn a return on that money. Even a small amount over a long period of time can make a difference when you retire. And if your tax bracket now is high, but you think it will be lower in retirement, then that opportunity cost increases. Also, if you don't intend to leave the money to your heirs and don't have estate tax issues, that advantage doesn't help you. In general, if you don't have the money to pay the taxes, you think your tax rate in retirement will be lower, and you are planning on spending the money in retirement and not leaving it for heirs, then it's likely this isn't your best option.

If opportunity has both an upside and a downside, then this new tax change clearly qualifies as an opportunity. But consider your own situation carefully - the right decision depends on it.

Related Articles
  1. Retirement

    How Much Money Do You Need to Retire at 56?

    Who wouldn't want to retire early and enjoy the good life? The question is, "How much will it cost?" Here's a quick and dirty way to get an answer.
  2. Retirement

    The Best Strategies to Maximize Your Roth IRA

    If a Roth IRA makes sense for you, here are ways to build the biggest nest egg possible with it.
  3. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  4. Taxes

    Tax Breaks For Volunteering

    Your volunteer ventures could earn you some welcome tax deductions, along with the satisfaction of helping others.
  5. Retirement

    5 Secrets You Didn’t Know About Traditional IRAs

    A traditional IRA gives you complete control over your contributions, and offers a nice complement to an employer-provided savings plan.
  6. Taxes

    Six Ways Your Tax Preparer Knows You’re Lying

    Cheating on your taxes is asking for trouble. You might get away with it, but you’re playing with fire and likely to get burned.
  7. Retirement

    Using Your IRA to Invest in Property

    Explain how to use an IRA account to buy investment property.
  8. Retirement

    How a 401(k) Works After Retirement

    Find out how your 401(k) works after you retire, including when you are required to begin taking distributions and the tax impact of your withdrawals.
  9. Retirement

    Are Fees Depleting Your Retirement Savings?  

    Each retirement account will have a fee associated with it. The key is to lower these fees as much as possible to maximize your return.
  10. Retirement

    Retirement Tips for Doctors

    Learn five tips that can help physicians get back on schedule in terms of making financial preparations they need to retire.
  1. When can catch-up contributions start?

    Most qualified retirement plans such as 401(k), 403(b) and SIMPLE 401(k) plans, as well as individual retirement accounts ... Read Full Answer >>
  2. Who can make catch-up contributions?

    Most common retirement plans such as 401(k) and 403(b) plans, as well as individual retirement accounts (IRAs) allow you ... Read Full Answer >>
  3. Can you have both a 401(k) and an IRA?

    Investors can have both a 401(k) and an individual retirement account (IRA) at the same time, and it is quite common to have ... Read Full Answer >>
  4. Are 401(k) contributions tax deductible?

    All contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. ... Read Full Answer >>
  5. Are 401(k) rollovers taxable?

    401(k) rollovers are generally not taxable as long as the money goes into another qualifying plan, an individual retirement ... Read Full Answer >>
  6. Are catch-up contributions included in the 415 limit?

    Unlike regular employee deferrals, catch-up contributions are not included in the 415 limit. While there is an annual limit ... Read Full Answer >>

You May Also Like

Trading Center