investment PLan Recent Changes Make Roth IRAs Attractive
[by Nick Houle]
E
arlier this year President Bush signed the Pension Protection Act which,
among other things, enhanced the Roth IRA. The legislation made the higher limits for both regular IRA and Roth IRA contributions permanent ($4,000 in 2006, $5,000 in 2008, and indexing for inflation thereafter). Catch-up contributions of an additional $1,000 per year were made permanent for people 50 or older. In addition, after 2007, individuals will be able to roll funds directly from an employer-directed plan, such as a 401(k), to a Roth IRA. After 2009, anyone no—matter what their income level—may convert some or all of their traditional IRA to a Roth IRA. (Currently, only those with an adjusted gross income (AGI) under $100,000 in the year of the conversion can qualify.) Created in the late 1990s, the Roth IRA is similar to a regular non-deductible IRA except that 100 percent of any investment growth inside the Roth IRA is tax-exempt when withdrawn. There The longer the time frame the are no required minimum distributions (RMD) at age 70½ (unlike a regular IRA), and in certain situations, better the investment return. the Roth IRA owner can access the funds without tax or penalty before 59½ if the distribution is a qualified When converting a regular IRA to a Roth distribution. IRA, timing is important. Because any taxIn order to make contributions to a Roth deferred amount converted is taxable in the IRA, an individual must have earned income year of conversion, it is advantageous for the at least equal to the amount contributed to IRA owner to be in a low tax bracket in the the Roth and have an AGI level for the Roth year of conversion to reduce the overall tax funding year under $150,000 for married cost of the conversion. Under the new rules, couples or $95,000 for individuals. Annual if a Roth conversion is done in 2010, an IRA contribution limits are generally the same owner may spread the taxable income from for Roth IRAs as regular IRAs. In contrast the conversion equally over two tax years. to a regular IRA, a contribution to a Roth is Converting could also make sense if the not tax deductible. IRA owner has special favorable tax considThe Roth IRA is a great way for young erations such as large charitable deductions, people to accumulate funds for long- income tax credits, Alternative Minimum term savings goals. For example, assume a Tax credits, or net operating losses.
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25-year-old adds $4,000 per year to a Roth until age 55 and the simple interest rate is 8 percent compounded annually. At age 55 the estimated balance in the Roth would be $489,000. At age 60 the balance is estimated to be $744,000. Generally the difference between a deductible regular IRA and a Roth is whether you pay the tax when you contribute to the account (Roth IRAs) or when you withdraw from it (deductible regular IRAs). Which account you invest in depends on your current marginal tax rates versus expected marginal tax rates in future years when the money is withdrawn. Higher marginal tax rates today might lead one toward deductible contributions today. The time period between when the IRA contribution is made and distributions are taken can also affect the decision (the longer the time frame the better the investment return). Also, there is no RMD at age 70½, so the money can stay in a Roth account much longer.
For those who do not anticipate using much or any of their IRA accumulations for living expenses, a conversion might make sense. Roth IRA balances are not subject to the RMD rules that affect regular IRA balances, so the Roth IRA balance grows tax-free for either the owner or the owner’s beneficiaries. For those who have other financial resources to pay the tax on the Roth conversion, the funds spent for taxes from those other sources will reduce the taxable estate of the IRA owner and “prepay” any income taxes that would be due on the regular IRA withdrawals by beneficiaries. In effect, the entire Roth IRA account would be transferred to the next generation income tax free. For individuals whose estates consist mostly of taxable IRA balances, converting to a Roth may make it easier to use the Roth IRA balance to fund all or a portion of the lifetime estate tax exemption amount. One final consideration for conversion is that in distributing regular IRA funds from a deceased IRA owner’s account, payouts to beneficiaries other than a surviving spouse begin in the year after the year of death. This may create taxable distributions earlier than planned. Funds paid from a Roth IRA are not “eroded” by income tax when paid out so the entire amount of the estate exemption is more efficiently utilized. For many, converting to a Roth IRA might wait until retirement years. Whether your motivation is to affect your own financial situation or your children’s inheritance, reviewing the powerful benefits of a Roth conversion should be part of everyone’s financial planning. Nick Houle is a managing financial advisor with LarsonAllen Financial, LLC, member NASD & SIPC. Contact Nick at nhoule@larsonallen. com or 612/376-4760.