The Roth IRA has been around for more than a decade. For 2010 and later, Congress removed the income and filing status restrictions on conversions to Roth IRAs. This caused a flurry of interest in Roth IRAs and their tax advantages.
The current tax law prevents higher income people from depositing directly into a Roth account (for example, married taxpayers with AGI [Adjusted Gross Income] over $167,000 to $177,000 for 2010). However, with the income restriction on conversions lifted, taxpayers of all earned income levels, and regardless of what type of retirement plans they have at work, can deposit, or contribute, funds into a non-deductible IRA (contributions are not deducted from income). The funds can then be converted to a Roth IRA. This strategy has caused a lot of buzz about Roth IRAs, since they are now open to almost everyone.
Traditionally, tax advisors have told their clients that it is better to take the deduction today and recognize the income later. However, as the tax laws change, this advice may not apply to your situation. With concerns about the overall economy, sluggish investment returns, lower retirement account values and potential future increases in tax rates, the time could be right to recognize income today with the thought of having tax savings in the future.
Roth accounts can offer a great tax savings in the right circumstances. Withdrawals from Roth IRA accounts are tax free if you follow the rules to make it a penalty-free, or qualified, withdrawal. Unlike the other retirement accounts, interest, dividends and the appreciation in account value are never taxed. Withdrawals are considered to be qualified withdrawals if the account owner is over 59 ½, the five-year waiting period since the account was established has passed or the withdrawal is a result of death, disability or used in the qualified purchase of a new home. There are also special provisions that allow the owner to withdraw their contributions, but not the earnings, without meeting the requirements above. However, you should seek advice before withdrawing funds for other than qualified reasons to avoid the 10% early withdrawal penalty.
Roth accounts do not require distributions (required minimum distributions or RMD) when the account holder reaches 70 ½. This allows the account to grow tax free until the funds are needed. The account holder can also pass the account to his or her heirs. In fact, people over 70 1/2 that have earned income, and meet the other requirements, can contribute directly to a Roth IRA. This is not possible with a traditional IRA.
As new developments emerge it’s important that people look at all the options and seek professional advice before converting to a Roth IRA. For example, with the signing of the Small Business Job Act in September 2010, some employers will begin offering a Roth 401(k) option. This adds another layer of complexity to an already difficult decision.
In Part II of this series, I will review why you might want to convert from a traditional IRA to a Roth IRA.
Everyone's situation is different. Get help from a trained CPA when you have questions.
--- Donna Boyette, CPA, Senior Accountant