Roth IRA changes could offer a better alternative

October 11, 2009 12:36 am

CHANGES are on the way that will affect who can convert into a Roth individual retirement account.

Income restrictions now prevent many people from taking advantage of a Roth IRA, whose distributions are generally tax-free. That will change in 2010, which will force high earners to decide whether to stick with a traditional IRA or convert to a Roth. There are also tax implications for 2010 conversions that might make it a good year to take action.

Deciding whether to convert to a Roth is an individual decision that investors must calculate based on their age, expected tax rate and need for withdrawals in retirement.

Regis Keddie III, an investment executive for Davenport & Co. in Fredericksburg, told me that clients are starting to ask about Roth conversions. We agreed it would be timely for this column to focus on that subject. Denise Short, a tax manager with PBGH in Fredericksburg, helped me understand the changes.

A Roth IRA is attractive to many investors because the distributions are tax-free, and penalty-free after the age of 59.5. Contributions are after-tax, meaning the money is taxed upfront rather than when tapped in retirement. People can also contribute to a Roth IRA after age 70.5, and there are no required distributions while the owner is alive.

These characteristics make Roth IRAs attractive to people who expect to be in a higher tax bracket when they're older. Because there are no mandatory withdrawals, and because investors can contribute their entire lives, Roth IRAs are a good investment vehicle for those who may not need the retirement funds but wish to leave them to their heirs.

Currently, people with modified adjusted annual gross income of more than $100,000 cannot convert into a Roth. But under a tax law signed by President Bush in 2005, the $100,000 limit will be waived starting in 2010, and anyone will be eligible to convert.

Investors will have to pay taxes to convert a traditional IRA into a Roth IRA. Usually the resulting income taxes must be paid for the tax year in which the conversion occurs. People who convert to a Roth in 2010 have two options for paying the tax.

They can either pay the income taxes in one sum for the 2010 tax year in 2011, or defer and split the payments between 2011 and 2012 at the prevailing tax rate in those years. That exception lasts just one year.

People with traditional IRAs also can decide to convert just part of their assets into a Roth and leave the rest in the traditional form.

Also, though income limits are waived for Roth conversions starting in 2010, they still apply for new contributions. In other words, people whose modified adjusted gross incomes exceed $100,000 can convert their traditional IRAs in 2010, but there are still income restrictions for new money contributed. But it is possible for these folks to contribute to a traditional IRA and then convert the money into a Roth.

People whose incomes are less than $100,000 don't have to wait until next year to convert. Some say this would be a good year to convert since many accounts have lost money, hence the tax bill may be lower.

As the above shows, the question "Which IRA is better, Roth or traditional?" is not an easy one. Many investment management companies have online conversion calculators that help with the decision.

Ultimately, it's an individual decision that tax advisers can help with. Still, it's important for investors to at least know the option is out there starting in 2010.

Staff reporter Bill Freehling writes this weekly column on business, personal finance and investing. He can be reached at 540/374-5405 or
Email: bfreehling@freelancestar.com.