It’s a Good Environment for Roth IRA Conversions

Most of us will not start the New Year happy about our investments. But if you are looking for a bright spot, it’s not a particularly bad time to consider converting a traditional IRA to a Roth IRA.
Right now, anyone with modified adjusted gross income of less than $100,000 a year (individual or joint income) can convert a traditional IRA account to a Roth IRA.  Higher-income Americans will get the same break in 2010 if Congress doesn’t reverse its 2006 approval of provisions in the Tax Increase Prevention and Reconciliation Act of 2005   (TIPRA).

Keep in mind that this also might be a good idea for people who were also unemployed or disabled during the past year and therefore had lower income. Talk to your tax professional about doing a full or partial Roth IRA conversion.

Remember that when you do a conversion, you must pay income tax on the amount you are converting, which can be all of the funds in the traditional IRA or just a portion of those assets. But, subject to certain restrictions, you won’t pay tax when you finally need to withdraw your money.  That’s where the silver lining comes in for you or for your heirs if you pass that money on to them.

Take another look at your statements and how much your investments are down. Assuming that the markets perform historically and fight their way back, your tax-free amount available for withdrawal could accumulate significantly under that Roth status.

The conversion issue is a potentially attractive retirement and estate-planning idea for all Americans who want to make sure they maximize the assets they have for themselves and for their heirs on a tax-free basis. But anyone considering such a move—regardless of his or her income status—should first review their current retirement asset strategy with a tax or financial adviser such as a CERTIFIED FINANCIAL PLANNER™ professional.

Things to consider:

The difference between a traditional IRA and a Roth IRA: Traditional IRAs allow investors to save money tax-deferred with deductible contributions (within certain income limits if either spouse is eligible for a qualified plan at work) until they’re ready to begin withdrawals anytime between age 59 ½ and 70 ½.  Roth IRAs don’t allow tax-deductible contributions, but they allow tax-free withdrawal of funds with no mandatory distribution age and allow these assets to pass to heirs tax-free as well. If you leave your savings in the Roth for at least five years and wait until you’re 59 1/2 to take withdrawals, you’ll never pay taxes on the gains. You can convert a traditional IRA to a Roth, but you must pay taxes on any pre-tax contributions, plus any gains.

Time to retirement matters: If you have more than five years until you plan to withdraw your retirement funds, conversion of traditional IRA assets to a Roth IRA might make sense.  The longer the time span where earnings can grow tax deferred, the greater the benefit of being able to withdraw those earnings without paying tax on them.

Your tax rate at retirement is important: Many people, such as business owners, may be paying taxes now at a fairly low rate. So they might pay higher taxes at retirement.  If that’s the case, converting to a Roth might make a lot of sense. Additionally, with Social Security benefits being taxable at certain income levels, Roth IRAs can allow you to limit or eliminate such taxes.

A Roth conversion can be expensive: You’ll have to pay taxes on contributions that you previously deducted, as well as taxes on the accumulated earnings.  Also, you need to be aware that conversion could push you into a higher tax bracket, especially if you’ve accumulated sizeable earnings over the years. This is why a conversion needs to be planned with a tax expert. Why? It may trigger the Alternative Minimum Tax (AMT) due to those high earnings.

January 2009 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Martin V Higgins,CFP, a local member of FPA.

Congress and the IRS disappointed investors in late 2008. The steep decline in IRA values caused many investors to ask for a suspension or reduction in required minimum distributions from IRAs and other qualified retirement plans for those over age 701,. Congress did not act, and the IRS said it had no authority to suspend the rules.

But changes were made for 2009 RMDs and you  should factor these changes into your planning. We first alerted members to these changes in December with a posting on Bob’s Journal on the members’ section of the web site. You should check the Journal regularly or subscribe to the RSS function that is explained on the site. (The RSS subscription is free.)

The penalty for failing to take an RMD from an IRA or other qualified retirement plan (50% of the amount that was supposed to be distributed) is waived for those who do not take RMDs in 2009. In effect the Worker, Retiree and Employer Recovery Act of2008suspendsRMDs for 2009. You can take whatever amount you want from your IRA in 2009, and that amount will be included in gross income. But you do not have to take the full RMD if you do not need it or want it. The idea is this gives the IRAs a better chance to recover some of their 2008 losses by compounding from a higher base.

The waiver applies to both original owners and to beneficiaries of IRAs and other qualified plans.

The next RMD will be for 2010 and will be based on the Dec. 3 1, 2009 value-if the law is not changed.

A tricky part of the change affects those who tum age 701/2 in 2009 so that their first RMD is due by April1, 2010. For these IRA owners, no distribution is required for 2009, meaning no distribution is required by April 1, 2010. However, those individuals will be required to take the regular2010 RMD by Dec. 31, 2010 using the Dec. 31, 2009 account value.

Likewise, someone who turned age 701, in 2008 still is required to take the first RMD by April 1, 2009 based on the Dec. 31, 2007, account value.

As we discussed last month, this is a good time to convert a traditional IRA to a Roth IRA. This law makes it a little easier. Under regular law, an RMD still must be taken in the year an IRA is converted to a Roth, and the RMD is included in gross income. In 2009, you can convert whatever amount you want (if your adjusted gross income is less than $ 100,000) and not worry about taking an RMD for the year. The full IRA can be converted.

The RMD always seemed to me to be bad policy. It is based on the notion that Congress should provide incentives to save for your retirement but only for your retirement. There shouldn’t be any money left to pass on to heirs unless you die prematurely. The law was developed at a time when life expectancies and retirement were much shorter. For several years there have been. Proposals to either eliminate the RMD or postpone it until a later age. Congress should use this crisis as a reason to take one of those actions.