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New Rules for Roth IRAs May Pave the Way for a Smoother Retirement

Americans are increasingly relying on their personal savings to fund retirement. The reasons for this include:
  • Employers are discontinuing their pension plans, shifting the responsibility for saving to individual employees.
  • Increased life expectancy has contributed to an overburdened social security system that, according to numerous reports, is expected to become insolvent in our lifetime.
And the retirement savings game is about to change again. Are you prepared for opportunity?

Traditional vs. Roth IRAs
Due to their favorable tax status and flexibility of investment choices, IRAs can be an effective investment vehicle for retirement savings. These accounts generally come in two flavors:
  • Traditional IRAs allow for pretax contributions (i.e., pay taxes later; avoid them now).
  • Roth IRAs allow for post-tax contributions (i.e., pay taxes now; avoid them later).
Rules differ regarding the funding, eligibility, and deductibility of Traditional and Roth IRAs. And with rules for Roth IRAs changing in 2010, it may be to your advantage to convert from a pay-later to a pay-now vehicle.

The new rules
Through 2009, only individuals with modified adjusted gross incomes (MAGI) less than $100,000 can convert qualified dollars to a Roth IRA. Beginning January 1, 2010, this $100,000 limit will be eliminated, permitting individuals who were previously barred from doing so to convert to a Roth IRA.

When you convert to a Roth IRA, you pay income tax on the taxable dollars that are converted. One benefit of the new rules, however, is that eligible individuals electing to convert in 2010 will be able 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).
Taxes due from conversions made after 2010, however, will be due in full in the year of conversion.

Reasons to consider a Roth conversion
There are many potential benefits to converting to a Roth IRA, but you should consult with a financial professional or a qualified tax advisor to determine whether it makes sense for you.

Tax-free withdrawals. Because retirement can now span 20 years or more, tax-free withdrawals have become more attractive. One reason to consider converting to a Roth IRA is if you believe your income tax rate may be higher in the future than it is today.

When you do a Roth conversion, you pay taxes today in order to receive a qualified, tax-free distribution later, as long you have had the Roth IRA for five years and the distribution is for one of the following reasons:
  • Age 59½ or older
  • Death
  • Disability
  • First-time home purchase
No required minimum distribution (RMD). Roth IRAs do not require that minimum distributions begin at age 70½. Which means, if you don't need this particular income stream in retirement, you can pay the taxes now, keep all of the Roth IRA money invested beyond age 70½, and avoid the annual income tax burden on RMDs.

Hedge against rising income taxes. No one has a crystal ball, but it is conceivable that taxes will increase. If you believe that your income tax rate will be higher in the future than it is today, you may want to consider converting to a Roth IRA.

An effective estate planning strategy. Roth IRAs may help you preserve assets for your heirs. Because distributions from a Roth are not required until a nonspouse beneficiary inherits the accounts, more assets can be preserved for future generations. Even when nonspouse beneficiaries must take RMDs, they can generally stretch those distributions based on their life expectancy—and the income is free from federal tax.

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? If you do, you may want to consider converting some of those assets. Supplementing retirement with nontaxable income may increase the likelihood that you will be in a lower tax bracket during your retirement.
  3. Can the conversion taxes be paid from a source outside of the IRA? It is generally better to pay these taxes with funds from another account; using IRA assets will typically result in more taxes and may involve early withdrawal penalties, depending on your age.
  4. Will I need access to the money within five years? If you think you will, then a Roth conversion may not be right for you at this time.
  5. Do I wish to leave tax-free income to my beneficiaries? A Roth IRA can be an effective means of preserving assets for heirs.
  6. Do I have retirement accounts that have suffered losses? You may have accounts with balances that aren't as high as they were prior to the market downturn in 2008. Converting these accounts to a Roth IRA while the values are low may result in a lower income tax.
Your answers will help your professional advisor(s) assist you in making the best decision. However you choose to fund your retirement, it is wise to be aware of the changing regulatory environment and how it may impact your future.

© 2009 Commonwealth Financial Network