There’s a savings vehicle in which all earnings, appreciation, and interest can be free of income tax forever. If the rules are met, there’s no RMD to be taken, no income tax due on withdrawals, and, while the account assets are included in your estate, withdrawals by your beneficiaries can also be tax-free. It hasn’t been available to everyone because of income limits, but it soon will be.
I’m speaking about the Roth IRA, of course. Until now, higher-income taxpayers ($100,000 modified adjusted gross income or higher) couldn’t convert their savings from a traditional IRA to a Roth. But that’s about to change.
While the rules around contributing to a Roth IRA aren’t affected*, beginning January 1, 2010, traditional IRAs held by taxpayers exceeding the income limits can be converted to Roths. Some of you have even planned ahead by making contributions to nondeductible traditional IRAs with plans to convert in 2010. As an added bonus, only for those conversions completed in 2010, the taxable income triggered by the conversion can be spread equally over two tax years.
I believe the Roth IRA is one of the best tools in a taxpayer’s arsenal for saving, accumulating assets, and then spending in retirement (or leaving to family). It’s right up there with the 401(k). An invention of the Taxpayer Relief Act of 1997, the Roth coincided in close proximity with reductions in income tax rates. Since contributions are after-tax, this made the Roth even more attractive.
This rule change will be an opportunity for increased tax diversification if your before- and after-tax holdings have been out of balance. This may be significant if you feel that income tax rates are likely to rise in the future. Converting traditional IRA assets to a Roth IRA in 2010 or later locks in the “tax cost” at then-current rates.
If you specifically want to use a Roth IRA to pass assets on to another generation in a tax-sheltered vehicle, conversion might be a good choice for you. Also, it may be the right move for a young job-changer with a rollover IRA and a low marginal tax bracket.
It may be more of a good thing. It may be too late for some. It may be a perfect opportunity for you. The decision is not without complications.
With the recent market downturn, it would certainly be less expensive, tax-wise, to convert now than it would have been before the recession. But is it worth it? After all, you’ll need cash from some other source to pay the taxes due. And if you’re nearing retirement and expect your income to be lower in retirement, you may want to walk away from a conversion.
You’ll be hearing a lot on this topic in coming months from Vanguard and other sources. Before making a decision, take some time, consider all the variables, talk to a professional tax advisor if you need to, and then determine if a Roth conversion makes sense for you.
* The maximum modified adjusted gross income limits to contribute to a Roth for 2009: $120,000 for individuals, or $176,000 for couples filing jointly. These limits will continue to apply in 2010, although the limit for joint filers will be raised to $177,000 in 2010 as a result of a cost-of-living adjustment.