Investment Strategy

08/14/06 - 2010 -- The Year of The Roth IRA?

By: Richard Feldman, CFP, MBA, AIF

The Roth IRA has been called one of the greatest retirement planning vehicles available for individuals and families but a major problem with the Roth is a lot of people do not qualify to open one due to income restrictions. That has all changed with the signing of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) that was signed into law on May 17th, 2006 by President Bush. A provision of the new act removes the $100,000 income limit for Roth Conversions in 2010 and provides a loophole in which individuals can now qualify for a Roth regardless of their income starting in 2010. This provision paves the way for individuals previously excluded from a Roth IRA or Roth conversion to plan their finances accordingly. Since this provision of the tax act does not take place until 2010, individuals and their advisors have four years to plan for the event.

Roth IRA Basics

Roth IRA distributions are tax-free if distributed after age 59 ½ and after the account has been open for five years. In addition Roth IRAs are do not have any mandatory required minimum distributions for owners who turn 70 ½.

Typically you have access to a Roth through three vehicles; a Roth IRA, Roth Conversion, and Roth 401K. The Roth IRA allows contributions in 2006 through 2010 in the amount of $4,000 and increasing to $5,000 in 2008 and beyond. If you are over the age of 50 you are eligible for a catch up contribution of $1,000 as well. The maximum annual Roth IRA contribution limit is phased out if your modified adjusted gross income is between:

$150,000 and 160,000, if you are married filing jointly, or a qualifying widow/widower;
$95,000 and $110,000, if you are single, head of household, or married filing separately and you lived apart for the entire year;
$0 and $10,000, if you are married filing separately and you lived with your spouse at any time during the year.

Another vehicle that you may access a Roth IRA through is a Roth Conversion. If your modified adjusted Gross income (MAGI) is $100,000 or less, and you are not married filing separately, you may make a taxable conversion of a traditional IRA or IRA rollover to a Roth IRA. This limit is for individuals who are single or married. TIPRA 2005 has alleviated the $100,000 MAGI limit for Roth Conversions starting in 2010 opening up a major financial planning opportunity for individuals and families that have been phased out of eligibility for a Roth IRA in the past or who have large IRAs and would like to convert aportion of their IRA accounts for tax and estate planning purposes.

Roth Conversions 2010

If you are not currently eligible for a Roth IRA due to income restrictions and you do not have access to the new Roth 401K through your employer sponsored retirement plan, you should try and build up the maximum amount of funds in an IRA as possible.

The main vehicle to accomplish this would be a non-deductible IRA. A non-deductible IRA provides tax deferred growth but does not provide for a current deduction for the contribution amount. You are eligible to contribute to a non-deductible IRA account if you have earned income and have not yet reached the age of 70 ½.

The contribution schedule for a non-deductible IRA for 2006 through 2008 is the lesser of:

$4,000 or $5,000 if you are age 50 or over ($1,000 catch up provision for age 50 and over);
Earned income.

The contribution schedule for 2008 through 2010 is the lesser of:

$5,000 or $6,000 if you are age 50 or over ($1,000 catch up provision for age 50 and over)
Earned income.

This means if you start out in the 2006 tax year and contribute the maximum every year through 2010 you would be able to contribute $23,000 individually and if you are married your spouse would be able to contribute the same amount. If your investments increased over the next four years your family would be able to convert over $46,000 to a Roth IRA. In addition if you and your spouse are over the age of 50 the amount increases to $28,000 individually and $56,000 including your spouse.

Taxes Owed on Conversion

Let's assume that an individual does not have any current IRAs or SEP-IRAs, is under the age of 50, and makes the maximum contribution to a Non-Deductible IRA from 2006 - 2010 and averages a 6% investment return on the non-deductible IRA assets. The nondeductible IRA would have grown to $25,732 over that time period. The taxpayer would have a basis of $23,000 in the non-deductible IRA and have $2,732 in earnings. The taxpayer would be able to convert the $23,000 to a Roth IRA tax free because these funds represent after tax dollars and are considered basis upon conversion. The earnings of $2,732 would be taxed at the individuals marginal tax bracket but the total conversion would be 89% tax free.

If an individual already has an IRA or SEP-IRA that is worth $100,000 and contributes the same amount to a non-deductible IRA as above and earns the same 6%. The rule regarding taxation of Roth IRA conversions is called the Pro-Rata Rule and would apply. If an IRA contains both nondeductible (after tax) and deductible (before tax) funds, then each dollar withdrawn will contain a percentage of tax free and taxable funds based on the percentage of after tax funds to the entire balance of the IRA accounts. You cannot pick and choose which funds to convert.

In our example $23,000 of the $125,732 total balance of all IRA accounts is considered basis and would be tax free if you converted the whole $125,732. If you however, only convert $50,000, $9,146.43 would be considered tax free or basis and the remaining $40,853.56 would be considered earnings and taxable. The percentage is computed by dividing the basis by the total IRA amount. In this case the computation of the Pro Rata Rule would be ($23,000/$125,732) or 18.29% of the $50,000 conversion gives you the $9,146.43 that would be tax free.

Another benefit of TIPRA 2005 is the ability to spread the taxability of the income from a 2010 Roth conversion ratably over the 2011 and 2012 tax years. Typically a conversion is taxable in the year of conversion but the TIPRA act of 2005 let's you choose to include in your taxable income in 2010 or spread the conversion ratably over the 2011 and 2012 tax years. The government would essentially be providing you an interest free loan for two years to pay the conversion tax. If you start planning in 2006 this would give you at six years to save the funds to pay for the tax on the conversion.

Summary

The relaxation of income limits on Roth IRA conversions in 2010 has created a major planning opportunity for families that will be subject to the estate tax and high income individuals that do not currently have access to a Roth IRA. Since individual circumstances, estate taxes, and future tax rates will determine if a Roth Conversion would be beneficial please consult your tax or legal professional for a detailed analysis.