January 2007

Imagine if your uncle threw a lavish party and didn’t invite all of the family.

That’s what Uncle Sam did when the Roth IRA was introduced nearly a decade ago. At the time, the new retirement account opened the door to tax-free investing but then promptly slammed it shut on those taxpayers who stood to benefit most.

“When Roth IRAs first came out, the income limits to either contribute or convert a traditional IRA locked out many affluent investors,” says Lisa Joseph, vice president in trust administration for Northern Trust. “Over time, people came to believe a Roth simply wasn’t available to them.”

That’s about to change.

Roth IRAs for everyone
New legislation was recently passed to preserve the best features of a Roth IRA while loosening restrictions on who can participate. Accounts are still funded with non-deductible contributions, which grow completely tax-free if withdrawn after at least five years and age 59½.

Lawmakers didn’t change the income requirements for making annual contributions (see “Do You Qualify for a Roth IRA?”). But here’s the good news: Starting in 2010, everyone can convert part or all of a traditional IRA to a Roth account, no matter how much money they make.

In other words, anyone who owns a tax-deferred IRA in 2009 can have a tax-free Roth in 2010 and beyond.

Taking action today
Although the new rules won’t take effect for a few more years, Joseph suggests that investors act now.

“If you’re still working and don’t qualify for a Roth, bear in mind that traditional IRAs have no income limits,” she says. “Invest the maximum there each year with the intention of converting in 2010.”

Similar advice also applies to a 401(k), which can be rolled into a traditional IRA when you leave your job and then converted to a Roth. You get an immediate tax break on today’s contributions and tax-free income throughout retirement.

If you’ve already hung up your briefcase, consider another advantage of converting — no mandatory withdrawals at age 70½. Unlike other retirement vehicles, Roth IRAs allow your entire account balance to grow without taxes for your later years or heirs.

“Ask yourself whether you’ll need your IRA assets during the first five years after conversion,” Joseph says. “If not, you’d probably be better off in a Roth, especially if you expect to be in the same or a higher tax bracket.”

Paying conversion taxes
Ah, yes, taxes. You didn’t think Congress would forget to take its cut, did you?

Remember, Roth IRAs are funded with after-tax dollars. When converting a traditional IRA, you’ll owe income taxes on all investment earnings and deductible contributions. In essence, you’re trading a tax bill now for tax-free withdrawals later.

Normally, taxes are due in the same year you convert, but the new law provides an added bonus. If you convert in 2010, you can postpone your tax liability for a year and spread it out over 2011 and 2012.

“It’s like getting an interest-free loan from the government,” Joseph says.

To convert or not to convert?
The question is, does a Roth IRA make sense for you? That answer depends on your responses to several other questions.

• Should you pay taxes upfront? All tax-deferred IRAs and employer plans will someday be subject to taxes. Depending on your situation, it may be better to pay the IRS before those accounts get even bigger.
   
• How will you pay conversion taxes? Ideally, that money will come from outside your IRA. If you start planning now, you have until 2011 to save what you’ll need.
   
• What will your tax rate be in retirement? Don’t automatically assume you’ll be in a lower tax bracket after retiring. What if you keep working part-time or make larger-than-expected taxable withdrawals? Or what if the tax code changes yet again?

  “Given our country’s budget deficit, there’s a good chance tax rates will go back up,” Joseph says. “The one certainty is that we’ll have a new president when most workers start tapping into their retirement assets. That could result in new tax legislation.”
   

• How much should you convert? You can convert only a portion of your traditional IRA to avoid a tax hit on the full balance. One rule of thumb is to convert just enough each year so that you don’t get bumped into the next highest tax bracket.

Put time on your side
The best news is that you don’t have to make any hard decisions right now. You have until 2010 to pump up your retirement accounts and ponder a possible conversion.

“Until then, use this time to sit down with your advisors and look at the big picture — budgets, taxes, income needs, estate plans,” Joseph says.

“The rules governing IRAs are complex and have been changing drastically. Investors need to choose wisely when deciding where to put their money, when to make changes and whom to trust for guidance.”