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An Old Tool Gets New Again
by   Mark Wade  

New rules
for Roth IRAs.

One of the most important provisions of the Tax Increase Prevention and Reconciliation Act, passed by Congress earlier this year, is the way it relaxes the rules regarding Roth IRA conversions. Starting in 2010, the income limits—which had prevented those with incomes over $100,000 from taking advantage of a Roth—will be eliminated, opening up this retirement planning tool for everyone.

That makes the Roth a potentially important retirement planning tool for people who are self-employed, and more likely to make use of an IRA rather than a 401(k), and also have a healthy income. In other words, it can be key for the kinds of professionals we have been talking about in our newsletter series. In this installment, we’d like to reintroduce you to this newly useful weapon in your investment arsenal.

TURNING TAXES AROUND

Does a Roth make sense for you?

Because of those income limits, you may not have paid much attention to the Roth IRA when it was introduced about ten years ago. The Roth IRA flips the tax advantage of a regular IRA on its head: While contributions to a regular IRA are tax deductible when they’re made, contributions to a Roth aren’t. But while you must pay income tax on distributions from an IRA, distributions from a Roth are tax free as long as you’re over 59½ and have had the account for at least five years. That means that wealthier people, like self-employed professionals, who have depended on IRAs for their retirement plans will now be able to shift their tax burdens to now, when they can most afford it, and enjoy a relatively tax-free retirement.

But even though the income limits will be gone, that doesn’t mean a Roth will become right for everyone. If you convert your IRA, you will owe income tax on the amount converted (what you would have paid had you waited until retirement to take the money). So it makes sense to convert only if you have the assets to cover those taxes.

In fact, it’s best to make the conversion if you don’t need the money right away in retirement. Unlike a 401(k), there are no mandatory withdrawals from a Roth at age 70½. That opens up a whole new strategic level to a Roth, as you can wait until it is to your maximum tax benefit to begin your withdrawals.

In addition, it also makes more sense to convert to a Roth if you expect to have lower tax rates when you start making your withdrawals. If you expect your IRA to be your primary source of income in retirement, that makes it more advantageous than it would be if you have several other sources of income as well, keeping you in a higher tax bracket.

 

 



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