How to Plan for New IRA Benefits in 2010

Retirement account owners, especially up-per income owners, will receive significant new tax benefits in 2010. These benefits can be maximized if a plan is established now and actions are taken over the next few years.

Two tax benefits begin in 2010, if Congress does not change the law.

The first benefit is the repeal of the income limit on those who want to convert traditional IRAs into Roth IRAs. Currently, a traditional IRA can be converted into a Roth IRA only if the owner has adjusted gross income of no more than $100,000 in the year of the conversion (excluding income recognized by the conversion). If a married couple files jointly, the same $100,000 limit applies to their joint income. Beginning in 2010, taxpayers of any income level will be able to convert their IRAs into Roth IRAs.

The second benefit is that there will be a brief window when the tax from the conversion can be deferred, then spread over two years.

Normally, when a traditional IRA is converted into a Roth IRA, the converted amount is included in gross income in the year of the conversion. The IRA owner pays tax as though the converted amount were distributed. For conversions in 2010, the IRA owner has an option. The owner can choose to pay no taxes on the conversion in 2010. Instead, the taxes can be paid in equal shares in 2011 and 2012. In effect, the government is making interest-free loans to encourage people convert IRAs in 2010.

There are several benefits to a Roth IRA. There are no deductions or other benefits when contributions are made, so there are no front-end tax benefits. As we have seen, there also are taxes due when a traditional IRA is converted to a Roth. The tax benefits begin after that.

Qualified distributions from a Roth IRA are completely tax free. A qualified distribution is one made at least five years after the Roth was established and when the owner is at least age 59½.

When the owner is not able to make tax-free qualified distributions, money still can be withdrawn tax free. Distributions are considered to first come from contributions, and the return of the contributions is free of taxes and penalties.

Another Roth benefit is there are no required minimum distributions after age 70½. Beneficiaries who inherit Roth IRAs must take RMDs but can spread them over their own life expectancies.

In past visits we have discussed when conversion to a Roth IRA enhances wealth. These articles are in the Archive on the members’ web site, and details are in my book, The New Rules of Retirement (available on amazon.com). There are calculators on various web sites to assist in the decision. Among others, visit www.RothIRA.com and www.troweprice.com.

As a general rule, the longer income and gains remain in the Roth to compound and accumulate, the more sense a conversion makes. The benefits of a conversion are increased if the taxes can be paid from other sources instead of by taking money from the IRA. The more money that you can allow to compound tax free and eventually be distributed tax free, the better off you are. Also, using money from other sources ensures that you won’t pay the early distribution penalty if you are under age 59½ and use the IRA to pay the conversion taxes.

Tax brackets are an important factor. If you will be in the same or a higher tax bracket in retirement as you are now, a conversion can make sense. But if you will be in a lower tax bracket in retirement, it might make sense to leave the money in a traditional IRA and withdraw it later at the lower tax rates.

A good general rule is that if most of the IRA will compound for at least another seven years, an IRA conversion should be considered. Web sites or financial advisors can help run the numbers to determine if conversion is a good deal. The rules for 2010 will make conversions a good idea for even more people than today.

IRA owners can enhance the conversion opportunity by getting ready for 2010 with the following steps.

Maximize IRA contributions. The more money you put into traditional IRAs now, the more you can convert in 2010. It even is sensible to make nondeductible contributions to IRAs with the intention of converting in 2010, because the money and its future income will be in a Roth IRA at some point. The taxes on the conversion will be very low because converting the nondeductible contributions won’t be taxable. The conversion will require more paperwork, and there might be taxes if you also own deductible IRAs.

Maximize employer plan contributions. A retirement plan account, such as a 401(k), cannot be converted directly to a Roth IRA. But the owner can roll over the 401(k) balance to a traditional IRA when the conditions for a rollover are met. Then, the traditional IRA can be converted into a Roth IRA.

Before executing this strategy, determine if a rollover from the 401(k) in 2010 will be viable. Generally, 401(k) amounts can be rolled over to an IRA only if the employee leaves the employer due to retirement, a new job, or disability. Some 401(k)s allow distributions or rollovers by any employee over age 59½. Check your plan’s rules and the tax law before deciding to ramp up contributions with an eye toward a conversion to a Roth IRA. If you are likely to switch jobs in 2010 or sooner, increasing the amount that eventually will be rolled over into a traditional IRA can make sense.

Increasing contributions can be wise even if a conversion is likely after 2010. While the 2010 rules make conversions more attractive, a conversion still is attractive to someone who will let the money compound for about seven years or longer. So, the strategy still can make sense for someone who is likely to switch jobs after 2010 and continue working for some years after that.

Consider estate planning. Many people want children and grandchildren to benefit from their IRAs, but do not want to simply name them as beneficiaries. They prefer to leave the money through a trust. But naming a trust as IRA beneficiary is fraught with complications and must be done properly to avoid losing the tax deferral benefits of the IRA.

A Roth IRA, however, does not have those complications. A trust can be named the Roth IRA beneficiary without the worry of triggering premature taxes if the wording is not correct. A conversion to a Roth IRA in 2010 might enhance your estate plan.

Shape up IRA accounts. Many people established IRAs when the contribution limit was lower and the contributions were deductible at any income level. They have not paid much attention to the IRAs since they lost the ability to deduct contributions. Now is the time to identify all those IRAs. Begin to consolidate them at the broker or mutual fund company at which you eventually want to have your Roth IRA.

Plan for the future. Maybe your IRAs are small. You think they aren’t worth the work of doing a conversion in 2010. But remember that the income limit for converting to a Roth IRA is repealed for all years beginning with 2010. That allows you effectively to make Roth IRA contributions every year beginning in 2010.

The strategy works like this. Establish a Roth IRA in 2010 with a conversion. Each year make contributions to a nondeductible IRA. Convert that IRA into a Roth by rolling the balance over to your existing Roth. Execute this plan each year. The result is that for a little extra paperwork you have avoided the contribution limit on Roth IRAs and established a tax free stream of retirement income. October 2006.