Shut Out of Roth IRAs No Longer
Thanks to some recent tax law changes,
high-net-worth individuals who are exploring additional ways to build
retirement savings may want to take a closer look at traditional IRAs. In May
2006, the Tax Increase Prevention and Reconciliation Act (TIPRA) revised some
of the guidelines covering IRAs. As a result, high-income investors whose
earnings level would previously have restricted them to a traditional IRA can
now convert those to Roth IRAs starting in 2010 and reap the long-term tax
advantages if they will be in the same or a higher tax bracket in retirement.
Because they allow qualified investors to
withdraw all contributions and those earnings that meet certain requirements
without federal income tax, Roth savings vehicles now appeal to a growing list
of investors. Previously, Congress limited Roth conversions to those whose
modified adjusted gross income was under $100,000. Under the new rules,
however, the conversions will be available to investors at any income level,
starting in 2010.
So if you’ve maxed out your 401(k) or 403(b)
contributions and don’t qualify to make Roth IRA contributions because of your
income level, you still can make nondeductible contributions to a traditional
IRA in 2009 and 2010 and then convert it to a Roth IRA in 2010.
Then, when needed during retirement,
investors can make withdrawals from the Roth IRA tax-free. Taxes will not be
owed on the original nondeductible contributions because they’ve already been
paid, although the previous earnings on those contributions will be
taxable. Those
who convert in 2010 only have the extra incentive of being able to spread the
tax liability over the following two years. Thereafter, all future earnings in the
Roth IRA will be available for tax-free distributions if certain requirements
discussed below are met.
With a traditional IRA, account holders are
taxed on both their original contributions and their investment earnings when
they start withdrawing money. Essentially, the tax responsibility has been
deferred, not eliminated. The tax responsibility for a Roth IRA comes at the
front end with nondeductible contributions. One of the advantages to account
holders, however, is that they do not have to pay any taxes — even on
investment earnings — at the time of withdrawal. And that means that Roth IRAs
essentially can make investment income tax-free income.
The opportunity to translate nondeductible
contributions into additional savings that could result in a tax-free income
stream for retirement is especially attractive for high-net-worth individuals
who can afford to pay the conversion taxes without using funds from the account
itself. By doing so, an investor can avoid paying taxes on the distribution as
well as an early distribution penalty of 10 percent. This assumes that a Roth
IRA has been open for at least five years and the investor is at least age 59½.
Moreover, because high-net-worth families often have retirement income from
other sources, they may not need to tap into their converted Roth IRA for many
years, if at all. (Unlike traditional IRAs, there are no mandatory withdrawal
rules for Roth IRAs if individuals are 59½ and the Roths have been established
for five or more years.) So investors who choose the conversion option can
theoretically shelter their earnings for years — an attractive advantage in
estate planning.
Here is a simple example of the potential
advantage of doing a Roth conversion: A married couple where both spouses are
under age 50 can make nondeductible contributions of up to $10,000 ($5,000 per
spouse) to traditional IRAs in 2009 and later. That amounts to $20,000 in
additional savings, excluding earnings, in 2009 and 2010. When the couple
converts their traditional IRAs to Roth IRAs in 2010, the taxes due will, unless
elected otherwise by the client, be paid for in equal installments in 2011 and
2012. All future earnings, however, will accumulate tax-free and all
withdrawals from the Roth IRA will be tax-free as well, if the distribution
requirements are met (i.e., later than age 59½ or five years after Roth IRA is
established). And that’s something all investors can appreciate.
If you'd like a personal calculation to determine if converting to a Roth IRA next year would be beneficial or if you have questions, give me a call, Donna C. Zill, Financial Advisor, The Shotz-Liguori-Zill Group at 386-615-3403 and I will make sense out of all of this.
Tax laws
are complex and subject to change. This information is based on current federal
tax laws in effect at the time this was written. Morgan Stanley Smith Barney and
its Financial Advisors do not provide tax or legal advice. This material was not intended nor
written to be used for the purpose of avoiding tax penalties that may be
imposed on the taxpayer.
Individuals are urged to consult their personal tax or legal advisors to
understand the tax and related consequences of any actions or investments
described herein.
Articles are published for general
information purposes and are not an offer or solicitation to sell or buy any
securities or commodities. Any particular investment should be analyzed based
on its terms and risks as they relate to your specific circumstances and
objectives.
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© 2009 Morgan Stanley Smith Barney
