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Whether You're Rich or Poor, 2010 is Important for IRA Tax Planning
By The BIDaWIZ Team - July 21, 2009
For those of you that aren't aware, starting in 2010, traditional IRA holders will be able to convert into a Roth IRA, even if your household earns over $100,000 in modified adjusted gross income a year. Currently, traditional IRA holders can only convert if their modified adjusted gross income for the year is under $100,000 (refer to IRS Publication 590).
What are the Main Differences/Similarities Between Traditional & Roth IRAs?
Comparison of Traditional IRA (pre-tax) vs. Roth IRA
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Traditional IRA
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Roth IRA
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Tax Deductible Contributions
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Yes1
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No |
$5K General Contribution limit ($6K if > 50 yrs old)
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Yes
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Yes
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Earnings & Principal Grow Tax Free
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No
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Yes |
Withdrawal Begins at 59 1/2
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Yes |
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Yes |
Mandatory Withdrawal by 70 1/2
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Yes
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No |
10% Early Withdrawal Penalty2
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Yes
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Yes
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Available to Everyone3
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Yes |
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No
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Funds Can Be Used for Many Investments
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Yes
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Yes
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Contributions Due by the April 15th4
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Yes
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Yes
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1Generally, you can deduct the lesser of your traditional IRA contributions for the year or the general limit (spousal IRA limit if applicable). There are certain limits if your spouse is covered by employer retirement plan, refer to IRS publication 590.
2All Traditional IRA funds (principal & earnings) are subject to early withdrawal. Roth IRA earnings are subject to early withdrawal penalty; principal can be withdrawn at any time without penalty. Refer to IRS publication 590.
3Roth IRAs are only available to those individuals whose income levels don't exceed a modified adjusted gross limit. Refer to IRS publication 590.
4Contributions must have been made by April 15th 2009 for the 2008 tax year.
How the 2010 Conversion Works
Starting in 2010, if you have a traditional IRA (no matter your income level), you can convert those funds into a Roth IRA. Your principal & earnings growth will be taxed at your marginal tax rate for converting the traditional IRA funds (pre-tax) into a Roth IRA (after-tax). If
your traditional IRA was initially funded with (after-tax dollars), you
would only be responsible for taxes on the appreciation. Please note that the taxes due can be paid over two years or 2011 & 2012. For conversions after 2010, taxes are due the same year as the year of the conversion.
Simulated 2010 Conversion Example
You have contributed $3,000 for the last 5 years into a traditional IRA (pre-tax) for a total of $15,000 of contributed capital. Now, the value of the traditional IRA is $20,000. You decide to convert your Traditional IRA into a Roth IRA and your marginal tax rate is 28%. You will be taxed on the contributed capital $15,000 (since at the time it was with pre-tax dollars) and the appreciation or $5,000 at your marginal tax rate. The total taxes would be $5,600. If your traditional IRA was initially funded with (after-tax dollars), you would only be responsible for taxes on the appreciation or $1,400 ($5,000*28%).
$15,000 Contributed to Traditional IRA (Pre-tax)
$5,000 Appreciation
$20,000 Value Today
$20,000 Converted to Roth IRA
28% Marginal Tax Rate
$5,600 Taxes Due in 2011 and 2012 For the Conversion
What Should I Do?
While it depends on your specific situation, there are a few general rules to follow:
1) Diversify Your Tax Exposure
While certain investments maybe the most tax advantageous today, tax laws change, and its best to give yourself choices if the time comes when you need the cash. In this specific instance, you may not want to convert everything into a Roth IRA because although there is tax-free appreciation, it is possible for tax laws to change.
2) Make Sure You Can Pay the Tax
By converting from a Traditional IRA to a Roth IRA, you will have to ask yourself if you can afford paying the cash for the taxes over the two year period or 2011 and 2012. If you can't, you have your answer, you can't convert.
3) Think About Your Family
If you just got married, you need to review your spouse's retirement plan and see if there are any restrictions on the contributions/deductions to IRAs. Make sure you diversify your tax risk as well.
Can Anyone Convert from a Traditional to a Roth IRA, Even the Rich?
Yes, even if you don't qualify to fund a traditional IRA on a pre-tax basis, you can still fund a traditional IRA with after-tax basis, thus giving you the ability to convert to a Roth IRA. While your contribution is after-tax, remember, your appreciation is tax-free.
More IRA Questions?
If you have additional questions, our Tax Wizards are Here to assist.
Have Comments? Write to comments@BIDaWIZ.com
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