Archive for Monday, January 4, 2010

Fiscal Fitness: 2010: The year of the Roth IRA

January 4, 2010


The Roth IRA has been available for more than a decade, but only a small percentage of people understand and utilize the benefits of this tax-free investment vehicle. Although many people roll over 401k accounts to Traditional IRAs, few take the next step of seizing more control over their future tax situation by either contributing to or converting to a Roth IRA.

Q: What makes a Roth IRA unique?

A: Most retirement plans (401k, Traditional IRAs, etc.) allow for tax-deferred savings to build until they are needed for future income. Contributions to these plans throughout the years are typically before taxes, so distributions are taxed as income at the time when they are withdrawn. The primary reason Roth IRAs are unique is because they allow for tax-free distributions. This can be extremely beneficial over the long-term. As these accounts have the opportunity to compound over the years, distributions can be taken after you are 59 1/2 without adding to your income. This is because any earnings within Roth IRAs are sheltered from further taxes.

Until Jan. 1, 2010, the typical ways to fund Roth IRAs were periodic and one-time contributions, or special rules that allowed conversions from accounts like Traditional IRAs. The problem for many people, however, is that these rules were restricted to specific amounts per year and to income limitations. A special IRS rule in 2010 will allow many people, who in the past could not, finally make use of the Roth IRA as a part of their investment strategy.

Q: What is special about 2010?

A: The IRS rule that allows for Roth IRA conversions is not new; it is just being relaxed in 2010. The main differences are 1) the income limitation has been removed for this year and 2) the tax burden can be taken in 2010 or spread across 2011 and 2012. Using the latter option, spreading the taxes out essentially adds half of the conversion to your taxable income in each of the two years.

Q: Is the conversion suitable for everyone?

A: When thinking about a conversion, the decision is unique to each individual situation. Although it seems like having tax-free income in the future is an overwhelming benefit, you should look closely at all options. Roth IRAs are best suited for those who do not intend to use the income stream for many years to fully benefit from the tax-free advantage.

The bottom line is that if you think your tax rates will increase over time and if you have many years before you will need the account for income, it may make sense to take advantage of this opportunity in 2010. The primary hurdle that most need to clear in order to convert is making sure they understand the short to intermediate-term tax implications. Even if conversion makes sense, you must pay the taxes between 2010-2012. That is why it is important to contact your financial and/or tax professional if you are unsure about how the conversion would affect your portfolio and tax situation.


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