Plan for a Roth IRA conversion in 2010

Plan for a Roth IRA conversion in 2010
Special tax savings opportunity for higher income taxpayers

A little bit of advance planning with a Roth IRA conversion can reap big financial rewards down the road.

Tax law enacted in 2006 allows for a special planning opportunity that arises in the year 2010, but only if you take the right steps now in order to take advantage of it.

The Roth IRA is different from a regular or Traditional IRA. Unlike Traditional IRAs that are typically fully taxable when distributions are taken, the Roth IRA provides for completely tax-free distributions once certain conditions are met.

Also, Traditional IRAs are subject to required minimum distribution rules (RMD), which require RMD distributions in the years following the year in which a taxpayer turns age 70 1/2.

These RMD rules force older taxpayers to take out distributions even if they don’t need to or want to take distributions.

The Roth IRA is not subject to the RMD rules, so older taxpayers can take tax-free money out of their Roth IRAs if they want to, or they can choose not to take distributions as they see fit.

The ability for the growth of assets within a Roth IRA to be fully tax-free is a huge benefit.

It is such a tremendous tax benefit that Congress decided higher income taxpayers should be disallowed from contributing to Roth IRAs.

Current tax law prohibits taxpayers with modified adjusted gross income (AGI) in excess of $100,000 from participating in a Roth IRA conversion.

Other rules disallow contributory Roth IRAs for single taxpayers with more than $116,000, or married joint filers with more than $169,000, of modified AGI.

But relatively new tax law has created a special planning opportunity that comes to fruition in a couple of years. A change was made in the tax law pertaining to Roth IRA conversions made in the year 2010.

The change, effective in the year 2010, eliminates the income limitation requirement that taxpayers have less than $100,000 in modified AGI. This change allows higher income taxpayers to do a Roth IRA conversion in the year 2010.

What this means is that higher income taxpayers can begin planning now for a Roth IRA conversion in 2010. Higher income taxpayers should seriously consider funding a Traditional IRA for the tax years leading up to 2010.

Consider the following example. Jeremy earns well in excess of $100,000. He also participates in a qualified retirement plan (401k plan) at work. Because his income is over $100,000, under current tax law Jeremy is not entitled to do a Roth IRA conversion.

Also, Jeremy is not entitled to make a deductible Traditional IRA contribution because he participates in a qualified retirement plan at work. However, Jeremy is entitled to contribute to a non-deductible Traditional IRA.

So, Jeremy funds $5,000 (with the catch-up provision, $6,000 if he is over age 50) into a non-deductible Traditional IRA for the tax year 2008.

Jeremy’s wife, Susan, also funds $5,000 (or $6,000 if over age 50) into a non-deductible Traditional IRA for the tax year 2008.

Jeremy and Susan also fund an additional $5,000 each (or $6,000 each if over age 50) to non-deductible IRAs for the tax year 2009.

Now, Jeremy and Susan have a combined amount of $20,000 ($24,000 if over age 50) in non-deductible Traditional IRAs. For the sake of simplicity, we will assume that both Jeremy and Susan are under age 50 for the rest of this example.

Because of good investment results, the $20,000 they invested in non-deductible IRAs has grown to $24,000 by the year 2010.

Jeremy and Susan then implement Roth IRA conversions, converting their non-deductible Traditional IRAs into Roth IRAs.

They pay taxes only on the $4,000 gain in their IRAs at the time of conversion. Also, the new law gives them an additional advantage in that it allows them to pay the taxes on this gain over two tax years—one-half in 2011 and one-half in 2012.

Many years later Jeremy and Susan both turn age 59 1/2 or older. At this time their Roth IRAs have a combined value of $100,000.

They decide to take full tax-free distribution of their Roth IRAs. They owe no taxes on the $76,000 in gain they realized.

If the money had been in Traditional IRAs, the gain would have been taxable. Jeremy and Susan are in the 35-percent tax bracket at the time of distribution.

They realize that their wise planning years earlier to take advantage of changes in the Roth IRA conversion rules has saved them over $25,000 in federal and state income taxes.

The rules for handling Traditional IRAs and Roth IRAs are so complex that many times you need expert advice and counsel to make informed decisions and avoid pitfalls and tax penalties.

Your particular goals, objectives, facts, and circumstances may dictate steps and decisions that are not readily apparent because of the complexity of the rules that may be involved. We recommend that you seek expert guidance regarding your IRA decisions.

George M. Hiller, JD, LLM, MBA, CFP® is the founder and president of the George M. Hiller Companies, LLC, an investment management, tax, estate, and financial planning firm based in Atlanta, Georgia. He is a member of Kingdom Advisors, a network of Christian financial professionals. ©2008 Crown Financial Ministries Privacy Policy