The New Roth IRA Rules for 2010
Don’t miss the chance to convert to a Roth IRA in 2010.
Since the New Year is just around the corner, you should know about the new rules that go into effect on January 1st of 2010 concerning Roth IRAs.
What are the Differences Between Traditional and Roth IRAs?
You may already know that IRA stands for Individual Retirement Arrangement and was formerly called an Individual Retirement Account. It’s a special account that gives the vast majority of U.S. citizens the ability to save considerable taxes on the growth of their retirement nest egg. Starting in 2010, the big change is that everyone will be eligible to convert a traditional IRA into a Roth IRA. Before we dive into whether a Roth conversion is a smart move for you, let’s review the major differences between traditional and Roth accounts.
Traditional IRA: With a traditional IRA you generally don’t pay taxes on the money that you put in. For example, if you earn $100, you can invest $100. You pay taxes on your income and earnings in the future, after you retire and begin to take qualified distributions from the account. That gives you an immediate tax break. You defer paying taxes on income and earnings until you withdraw money from the account. So instead of getting taxed on the amount of money you put in the account, you get taxed on the amounts that you eventually take out.
Roth IRA: A Roth IRA, on the other hand, has the opposite taxation requirement because you must pay tax on money before you invest it. Paying taxes up front can be a disadvantage when compared to a traditional account if it means that you won’t invest as much. For example, let’s say you earn $100 and want to contribute it to a Roth IRA. If you’re in the 25% tax bracket, you’d have to pay $25 in taxes before making the contribution. That would only leave you with $75 to put in the Roth account. Investing with your after-tax money could end up being less total money over the long run when compared to investing your pre-tax money in a traditional IRA.
But when you take a qualified distribution from a Roth IRA during retirement, you don’t owe any taxes on it. That’s because you already paid taxes on the money before you contributed it. That can be a huge advantage because investments in a Roth IRA grow completely tax-free!
What are the Benefits of a Roth IRA?
You just read two words that are music to investors’ ears: tax free! Many people would love to take advantage of tax-free growth in a Roth--but guess what? Some people make too much money to contribute to a Roth. For 2009, the upper income limit for a single taxpayer is $120,000 or $176,000 for married taxpayers who file a joint return. If you already have a Roth IRA and find that your income will exceed the allowable limit, you can keep the account, but are prohibited from contributing any additional money to it.
Besides tax-free growth, there are a couple more advantages to a Roth IRA. One is that you can fund it at any age. That’s different from a traditional IRA because you can’t make contributions to it after the age of 70½. Another benefit of a Roth IRA is that owners are never forced to take a distribution, whereas traditional IRA owners must begin taking distributions starting at age 70½.
What is a Roth IRA Conversion?
If you make too much money to fund a Roth IRA, another way to open one is to convert funds in a traditional IRA to a Roth. And by the way, you can convert the entire amount in your account or just a small portion of it. When you do a Roth conversion you must pay taxes on any funds that weren’t already taxed. But get this--the IRS has put a special incentive in place to help you manage the tax liability for doing a conversion in 2010. Here’s how it works: if you make a Roth conversion from January 1st to December 31st of 2010, you’re allowed to split the tax liability equally between the next two tax years--2011 and 2012.
For example, if you were in the 25% tax bracket and converted $10,000 of un-taxed funds, your tax bill would be $2,500. But by completing a Roth conversion in 2010, you’d qualify to defer taxes on the transaction for that tax year. In other words, on April 15th of 2011 you wouldn’t owe the IRS a dime for the 2010 conversion. Instead, you’d owe half, or $1,250 for the 2011 tax year and the remaining $1,250 for the 2012 tax year.
Deferring taxes on a 2010 conversion and paying them over two years can be a nice benefit unless your tax bracket rises. For instance, if your income were to significantly increase in 2011 or 2012, remember that you could end up paying a higher tax rate for the converted money.
Who Can Do a Roth Conversion?
Up until now, doing a Roth conversion has only been allowed for those with modified adjusted gross income below $100,000. But starting in 2010 the $100,000 income restriction is lifted. Now everyone is eligible to convert a traditional account into a Roth IRA, regardless of income. Doing a conversion is a great opportunity for high earners to put their retirement money in a vehicle where it can grow tax-free.
However, be aware that even if you convert funds to a Roth IRA, the income limits for making contributions still apply. So if you make too much money (remember, that’s over $120,000 for single filers and over $176,000 for joint filers in 2009) you won’t be eligible to contribute new funds to your Roth nest egg. But that’s okay because the investment will grow tax-free for as many years as you keep it in the account.
Should You Do a Roth Conversion?
Here are four questions to help you think over some of the major issues involved in doing a Roth conversion:
Do you think U.S. income tax rates will be higher in the future, when you’ll need your IRA money? If so, paying a lower tax rate now for a Roth conversion is a better option than paying a higher tax rate on traditional IRA funds later on.
Do you think your income tax bracket will be higher when you retire than it is now? That’s usually the case for young workers who are just beginning their careers. Again, paying less tax sooner, rather than more tax later, is better.
Can you pay the tax liability for converted funds from sources other than your IRA? If you convert in 2010, the government is giving you some extra time to save up for the tax bill.
Did your traditional IRA take a beating in the last couple of years? If it hasn’t fully recovered, having a lower account value means you’ll pay less conversion taxes than if the account value was higher. That’s a way to make lemonade out of financial lemons!
As you can tell, the traditional vs. Roth IRA question is not a simple one. At dinkytown.com, the Roth IRA Conversion calculator will show you what advantage, if any, doing a conversion will give you. Also take a look at dinkytown’s Roth vs. Traditional IRA calculator to understand which type of account may be right for you.
If you decide to do a conversion, contact the custodian of your IRA and let them know your plan. Of course, everyone’s situation is different, so it’s a good idea to speak with an accountant or a financial advisor about whether converting to a Roth is best for you.
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