2010 Roth IRA Conversion: What You Need to Know

Starting January 2010, anyone can convert a traditional IRA into a Roth IRA. In the past, only those earning less than $100,000 were eligible to do contributions to Roth IRA (even after January 2010, contribution to Roth IRA starts to phase out if you earn more than $100,o00). According to media reports, this conversion opens up 13 million households holding $1.4 trillion IRAs. Conversions can be complicated and moving to a Roth IRA requires careful planning. An individual retirement arrangement (IRA) is a personal savings plan that offers specific tax benefits. IRAs are one of the most powerful retirement savings tools available to you. Even if you’re contributing to a 401(k) or other plan at work, you should also consider investing in an IRA.

The California Society of CPAs is the nation’s largest state, non-profit professional association representing more than 30,000 CPAs in the area of tax, accounting and consulting services such as personal finance. California CPAs suggest the following strategies to consider in 2010 when using IRAs:

Step 1: Understand Basic Tax Issues

Any funds you shift during the tax year, other than amounts that represent nondeductible (after-tax) contributions to your traditional IRA, are treated as taxable income for that year. This means that if the contributions originally made to your traditional IRA were deductible, you may have to pay income tax on the amount shifted to the Roth IRA. Also, although the premature distribution tax (for IRA withdrawals prior to age 59½) does not apply when you shift funds to a Roth IRA, it may apply if you later withdraw from the Roth IRA within five years after you shift funds. Finally, you cannot shift required minimum distribution amounts from a traditional IRA to a Roth IRA. Given the possible tax consequences of this conversion, you may wish to consult experienced tax and financial professionals before you commit to the process.

Step 2: Understand What Types of IRAs Are Available?

The two major types of IRAs are traditional IRAs and Roth IRAs. The Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Tax Act) increases the annual IRA contribution limit to up to $5,000 for 2008 and beyond. You must have at least as much taxable compensation as the amount of your IRA contribution. But if you are married filing jointly, your spouse can also contribute to an IRA, even if he or she does not have taxable compensation. The law also allows taxpayers age 50 and older to make additional “catch-up” contributions.

Both traditional and Roth IRAs feature tax-sheltered growth of earnings. And both give you a wide range of investment choices. However, there are important differences between these two types of IRAs. You must understand these differences before you can choose the type of IRA that’s best for you.

Step 3: Learn the Rules for Traditional IRAs

Practically anyone can open and contribute to a traditional IRA. The only requirements are that you must have taxable compensation and be under age 70½. You can contribute the maximum allowed each year as long as your taxable compensation for the year is at least that amount. If your taxable compensation for the year is below the maximum contribution allowed, you can contribute only up to the amount that you earned.

Your contributions to a traditional IRA may be tax deductible on your federal income tax return. This is important because tax-deductible (pretax) contributions lower your taxable income for the year, saving you money in taxes. If neither you nor your spouse is covered by a 401(k) or other employer-sponsored plan, you can generally deduct the full amount of your annual contribution. If one of you is covered by such a plan, your ability to deduct your contributions depends on your annual income (modified adjusted gross income, or MAGI) and your income tax filing status. You may qualify for a full deduction, a partial deduction, or no deduction at all.

Step 4: Know the Penalties

What happens when you start taking money from your traditional IRA? Any portion of a distribution that represents deductible contributions is subject to income tax because those contributions were not taxed when you made them. Any portion that represents investment earnings is also subject to income tax because those earnings were not previously taxed either. Only the portion that represents nondeductible, after-tax contributions (if any) is not subject to income tax. In addition to income tax, you may have to pay a 10 percent early withdrawal penalty if you’re under age 59½, unless you meet one of the exceptions.

If you wish to defer taxes, you can leave your funds in the traditional IRA, but only until April 1 of the year following the year you reach age 70½. That’s when you have to take your first required minimum distribution from the IRA. After that, you must take a distribution by the end of every calendar year until you die or your funds are exhausted. The annual distribution amounts are based on a standard life expectancy table. You can always withdraw more than you’re required to in any year. However, if you withdraw less, you’ll be hit with a 50 percent penalty on the difference between the required minimum and the amount you actually withdrew.

Step 5: Learn the Rules for Roth IRAs

Not everyone can set up a Roth IRA. Even if you can, you may not qualify to take full advantage of it. The first requirement is that you must have taxable compensation.

Your contributions to a Roth IRA are not tax deductible. You can invest only after-tax dollars in a Roth IRA. The good news is that those contribution amounts will be income tax free when you withdraw them. Better yet, if you meet certain conditions, your withdrawals from a Roth IRA will be completely income tax free, including both contributions and investment earnings. To be eligible for these qualifying distributions, you must wait at least five years after making your first contribution to the Roth IRA (the five-year rule). In addition, one of the following must apply:

• You have reached age 59½ by the time of the withdrawal
• The withdrawal is made because of disability
• The withdrawal (of up to $10,000) is made to pay first-time home-buyer expenses
• The withdrawal is made by your beneficiary or estate after your death

Qualifying distributions will also avoid the 10 percent early withdrawal penalty. This ability to withdraw your funds with no taxes or penalties is a key strength of the Roth IRA. And remember, even non-qualifying distributions will be taxed (and possibly penalized) only on the investment earnings portion of the distribution, and then only to the extent that your distribution exceeds the total amount of all contributions that you have made.

Another advantage of the Roth IRA is that there are no required distributions after age 70½ or at any time during your life. You can put off taking distributions until you really need the income. Or, you can leave the entire balance to your beneficiary without ever taking a single distribution. Also, as long as you have taxable compensation and qualify, you can keep contributing to a Roth IRA after age 70½.

Step 6: Choose the Right IRA for You

Assuming you qualify to use both, which type of IRA is best for you? Sometimes the choice is easy. The Roth IRA will probably be a more effective tool if you don’t qualify for tax-deductible contributions to a traditional IRA. However, if you can deduct your traditional IRA contributions, the choice is more difficult. Most professionals believe that a Roth IRA will still give you more bang for your dollars in the long run, but it depends on your personal goals and circumstances. The Roth IRA may very well make more sense if you want to minimize taxes during retirement and preserve assets for your beneficiaries. But a traditional deductible IRA may be a better tool if you want to lower your yearly tax bill while you’re still working (and probably in a higher tax bracket than you’ll be in after you retire). A financial professional or tax advisor can help you pick the right type of IRA for you.

Step 7: Know Your Options for Transferring Your Funds

You can move funds from an IRA to the same type of IRA with a different institution (e.g., traditional to traditional, Roth to Roth). No taxes or penalty will be imposed if you arrange for the old IRA trustee to transfer your funds directly to the new IRA trustee. The other option is to have your funds distributed to you first and then roll them over to the new IRA trustee yourself. You’ll still avoid taxes and penalty as long as you complete the rollover within 60 days from the date you receive the funds.

Step 8: Do Additional Research

The California Society of CPAs (www.CALCPA.org) has created a free Web site of articles, tools and resources to help families with retirement and savings issues. These resources can be accessed by going to: “Dollars and Sense”