The Roth IRA Opportunity

Roth IRAs are one of the best tax-advantaged investment vehicles. Right now they are available to only taxpayers with incomes below certain levels. In a couple of years, all investors will be able to take advantage of this opportunity by converting traditional IRAs into roth iras. Those whose incomes make them ineligible for Roth IRAs today can prepare to maximize the benefits when Roths become available to them in 2010. In fact, anyone considering converting an IRA into a Roth IRA in 2008 or 2009 should weigh the advantages of waiting until 2010 to do the conversion.

A Roth IRA has back-loaded tax benefits. There is no deduction for contributing money to a Roth. All income and gains earned by the Roth compound free of taxes. Distributions are tax free if they are made after the later of when the taxpayer first made a contribution to any Roth IRA and one of the following: the owner attained age 59½, is deceased, became totally disabled, or the distribution is of up to $10,000 and is used for the qualified purchase of a first home. Required minimum distributions are not imposed on the original owner; a beneficiary who inherits a Roth IRA takes RMDs over his or her life expectancy.

Many of my readers are not able to open Roth IRAs because of the income limits on contributions. The tax law allows traditional IRAs to be converted into Roth IRAs, but only taxpayers with adjusted gross incomes of no more than $100,000 (before including a converted IRA amount) can do a conversion.

Beginning in 2010, however, the income limit on conversions is removed. In addition, there is an incentive for taxpayers to convert traditional IRAs into Roth IRAs in 2010, which we will discuss shortly.

There is a cost to converting a traditional IRA into a Roth IRA. The amount converted must be treated as if it were distributed by including it in gross income. If the owner is under age 59½ the 10% early distribution penalty is not imposed on a converted amount (but is imposed on any amount actually distributed to pay taxes on the conversion.)

Example. Max Profits owns a traditional IRA to which he made deductible contributions that has a balance of $100,000. If Max converts the entire amount, then $100,000 must be included in gross income in the year of the conversion. If $50,000 is converted, then $50,000 is included in gross income. If the IRA has nondeductible contributions, the nondeductible contributions can be converted into a Roth but will not be included in gross income in the year of the conversion.

All or part of an IRA can be converted. A taxpayer can choose to convert one IRA but not others he or she owns, or all the IRAs a person owns can be converted.

When does it make sense to convert a traditional IRA to a Roth IRA? There are several factors to consider.

• How will taxes on the conversion be paid? The conversion is more valuable if the taxes are paid from non-IRA accounts so that the entire IRA is converted and begins compounding. If part of the IRA must be distributed and used to pay taxes, it takes longer for the conversion to pay off. In that case, if the IRA earns 8% annually it should be left to compound for at least 10 years before distributions begin.

  Because of this it might make sense to convert an IRA over a period of years. Determine how much cash is available outside the IRA to pay income taxes, and convert the appropriate amount of the IRA for that level of taxes. More of the IRA can be converted in later years as cash is available to pay the taxes.

• How long will the Roth IRA be left to compound before distributions begin? The converted amount must be allowed to compound its income and gains to make up for the taxes that were paid. If conversion taxes are paid from a taxable account and the IRA earns at least 8% annually, it takes at least seven years of compounding to reach the break even point. A longer compounding period generates more after-tax wealth for the owner than keeping the traditional IRA would have. A lower rate of return means a longer compounding period is needed to break even.

• Will the tax rate be different when distributions begin? If the tax rate will be lower than it is today, it might not make sense to pay taxes at today’s rate unless there is a substantial compounding period.

• Will future Social Security benefits be taxable? If the taxpayer estimates having a high enough retirement income for benefits to be taxed, a conversion could reduce those future taxes. The Roth distributions are not included in gross income under current law while traditional IRA Distributions are. If IRA distributions will be a big part of retirement income, shifting them to a Roth could save the Social Security benefits from taxes.

• Will required minimum distributions from the traditional IRA exceed spending needs? When an owner has a large IRA and enough assets outside the IRA to meeting living expenses, it might make sense to empty the IRA early. We have discussed this in past visits and in my book, The New Rules of Retirement. The RMDs force unneeded distributions and increase income taxes.

  An alternative to emptying the IRA early is to convert the IRA to a Roth IRA. This is not possible for many owners of large IRAs because of the income limit, but it will be possible in 2010 when the income limit is removed.

• What will state income taxes be? Not all states exempt Roth IRA distributions from income taxes. This should be checked before a conversion is undertaken.

Many mutual funds and other financial services firms have calculators on their web sites to help determine if converting to a Roth IRA will increase after-tax wealth. A good calculator also can be found at www.rothira.com. A few of other calculators with no ties to financial products or services are at www.datachimp.com, www.voli-tion.com, www.dinkytown.com, and www.customcalcu-lators.com. Financial planners of course can provide calculations.

There are incentives to convert to a Roth IRA in 2010. One incentive as mentioned is the elimination of the $100,000 adjusted gross income limit.

The second incentive allows the conversion tax to be paid over time. The owner can choose to pay taxes on the conversion in 2010 or 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.
IRA owners can enhance a conversion to be made in 2010 by bulking up traditional IRAs today. They can make IRA contributions, even if they are nondeductible. That will increase the future income and gains that could be distributed tax free after the conversion. Maximizing contributions to 401(k) or other plans can make sense if there might be a job change or other event that triggers a rollover of the 401(k) to the IRA. The rolled over amount then can be converted to a Roth IRA.

It is possible that Congress could repeal either the removal of the $100,000 ceiling or the option to defer taxes on the conversion, or both. That would be the risk of planning now to make a conversion in 2010.

A potential cost to doing a conversion in 2010 instead of today (for those who are eligible today) is that the IRA might be worth much more in 2010, triggering higher taxes than would be due today. Those who are eligible to do a Roth conversion this year might want to do one soon, while most markets are at low points. If the markets fall further, the conversion can be reversed. Converting at a relatively low cost might be better than waiting for the 2010 incentives.

IRA owners should consider each year whether a conversion would be profitable. After a conversion is done, the IRA and tax situation should be monitored. The owner might want to reverse the conversion, something we will discuss in an upcoming visit. March 2008.