New Rules for Roth IRAs

Presented by Bradley Bronk, CFP^®

Roth IRAs, despite their attractive features, have yet to match the popularity of traditional Individual Retirement Accounts (IRA).  One reason Roth IRAs constitute such a small percentage of total retirement assets, just 5%, is that many wealthier individuals, who potentially stand to benefit the most from them, have been ineligible either to contribute to one or to convert their existing traditional IRAs to a Roth IRA.  As of year-end 2008, over $3.5 trillion was invested in traditional IRAs compared with a mere $165 billion in Roth IRAs.¹

The Tax Increase Prevention and Reconciliation Act of 2005 changed tax laws regarding the conversion of a traditional IRA to a Roth IRA.  The act specifically allows anyone to convert their traditional IRA to a Roth IRA regardless of their adjusted gross income (AGI), beginning January 1, 2010.  This is a unique opportunity that was not available to everyone in the past.

What is a Roth IRA?

A Roth IRA is a retirement investment vehicle in which all earnings are tax free when distributions are taken. Other benefits include eliminating the need to take minimum distributions after age 70½ and avoiding the early distribution penalty on certain withdrawals.

There is an array of investment options to choose from including, but not limited to, cash, certificate of deposits, bonds, mutual funds, and stocks.

Note:  Withdrawals of earnings are tax free if you're over age 59½ and at least five years have expired since you established your Roth IRA. Otherwise, with limited exceptions, they are taxable and potentially subject to the early withdrawal penalty.

The New Rules

Through 2009, only individuals with AGIs less than $100,000 could have converted traditional IRA dollars to a Roth IRA.  This $100,000 AGI limitation was eliminated this year, allowing anyone who was previously barred from converting an IRA to Roth IRA to now convert.

If converting in 2010, the new rule allows individuals to spread out their income tax payment in equal installments over two years:

• Pay 50 percent of the tax burden in 2011 (generally due on April 15, 2012).
• Pay the remaining 50 percent in 2012 (generally due on April 15, 2013).

That makes 2010 an outstanding time to convert to Roth IRAs, as conversions after 2010 will be taxed in the year of conversion (i.e. generally due in full by April 15^th of the following year)

Nondeductible Traditional IRA Conversions – Great Opportunity!

The new rules also apply to “nondeductible” IRAs!  If you have a nondeductible traditional IRA you can convert this into a Roth in 2010 and pay taxes ONLY on any increase in value between your original investment and the converted amount!  For example, if you contributed $5,000 to a nondeductible IRA each year for the last three years you would have a cost basis of $15,000.  If the current value of this investment is $16,000 and you convert your IRA into a Roth IRA, you would pay income taxes only on the $1,000 growth and have yourself a $16,000 Roth IRA.

The decision to convert becomes more complex when you have both qualified and nondeductible IRAs and convert to a Roth.  Aggregation rules disallow individuals from "cherry picking" which assets to convert to a Roth IRA.  Instead, all IRAs must be lumped together. For example, John wishes to convert $25,000 in his nondeductible IRA to a Roth IRA.  John also has $75,000 in a rollover IRA. John will need to combine both IRAs to calculate the percentage of nondeductible assets to total IRA assets, then apply that percentage to the amount of assets converted to determine the nontaxable amount that was converted.

Is Converting to a Roth IRA Right for You?

Consider the following important questions:

1. Do I expect tax rates to be higher or lower when I retire?
2. Do I have a large percentage of assets in traditional IRAs?
3. Can the conversion taxes be paid from a source outside of the IRA?
4. Will I need access to the money within five years?
5. Do I wish to leave tax-free income to my beneficiaries?
6. Do I have retirement accounts that have suffered losses?

However you choose to fund your future, it is important to be aware of the changing regulatory environment and how it may impact your future.

¹Investment Company Institute^®:  2009 Investment Company Fact Book

Bradley Bronk, CFP^®, is a CERTIFIED FINANCIAL PLANNER™ practitioner at 990 Enchanted Way Suite 104, Simi Valley, CA 93065.  Bradley offers securities and advisory services as an Investment Adviser Representative and Registered Representative of Commonwealth Financial Network^®, a member firm of FINRA/SIPC and a Registered Investment Adviser.  Bradley can be reached at 800-266-7788 or www.bronkfinancial.com.