New Tax Breaks You Need To Know

By Douglas Rice | December 08, 2009 AAA

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.

Conclusion
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.

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