December 7, 2009

By Harry C Ballman, MBA, CPA, PFS; Arthur J Dykes, CPA; Donald S Paris, CPA.

It is truly an ill wind that blows no good. So what’s the point? In the near future over 13 million middle income and high-income investors will have access to an invaluable tax planning opportunity that has been out of their reach. The new strategy is especially compelling when asset values are depressed as is currently the norm. What is this counterintuitive strategy that is tailor made for a depressed market, and that has previously been unavailable to so many? Three words: Roth IRA Conversion.

The Roth IRA conversion option has been around since 1998, but been available only to households with $100,000 or less of modified adjusted gross income (MAGI).

When an individual converts a traditional IRA to a Roth IRA they have to pay income taxes on any pre-tax contributions as well as any growth in the investment’s value. After all, once converted to a Roth, all of the investment could now be withdrawn on a tax-free basis in retirement. However, converting to a Roth IRA when the market is depressed substantially reduces the tax bite.

What’s Changing? Thanks to a provision in the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005, the income restriction on Roth IRA conversions is set to be lifted as of January 1, 2010.

What’s more, the federal tax laws contain a special tax alternative for individuals who decide to convert in 2010. While the entire taxable amount of a conversion is typically included in taxable income in the year of conversion, taxpayers who convert assets during 2010 will have the option to forego taxes on the conversion in 2010 and, instead, include the taxable portion of the conversion in income taxes ratably on their 2011 and 2012 returns. Whether this tax-spread will be advantageous for a given taxpayer will depend on a variety of factors including the taxpayer’s expectations for federal income tax rates in 2011 an 2012. Conversions in subsequent years are included in income during the tax year in which the conversion is completed.

While Roth IRAs do not offer the benefits of tax deductible contributions, Roth IRAs do allow taxpayers to accumulate earnings on a potentially tax-free basis when distributed. For Roth IRA earnings to qualify for tax-free "qualified distribution" at least five years must elapse from the time of the Roth IRA owner’s first Roth IRA contribution, and the IRA owner must generally be at least age 59. However, Required Minimum Distributions are not required from Roth IRAs and are generally tax free when distributed as mentioned above.

Fortunately there is a way for all taxpayers - regardless of income - to take advantage of this change in the tax code:

Start Funding a Traditional IRA Right Now!

Even if you don’t qualify to make Roth IRA contributions or traditional IRA contributions on a before-tax basis, you can still make after-tax contributions to a traditional IRA. If you invest in a non-deductible IRA in the tax years 2009 through 2010, then you can convert those IRAs to Roth IRAs in 2010.

You may shy away from making non-deductible contributions to a Traditional IRA because they are not tax deductible, the investment growth is fully taxable, and because they are subject to minimum distribution rules they offer only a minimal tax shelter. But by converting these non-deductible IRAs to Roth IRAs in 2010 many of those disadvantages disappear.

While it might be very exciting for some individuals to learn that they can use this 2010 law to convert an IRA to a Roth IRA, please know that Roth IRAs are not for everyone. Before converting you should further explore the differences between a Roth IRA and a Traditional IRA that can be found at WWW.ROTHIRA.COM, and you might also want to run through some what-if scenarios using a Roth versus Traditional IRA calculator by doing a Google search: Traditional vs. Roth IRA calculators.

Of course, it’s always best to make an informed decision by examining all the facts surrounding your financial situation. Further, when you have questions about what’s right in your particular situation it is wise to consult your tax /financial professional before deciding if this strategy is right for you.