New tax law changes that take effect in 2010 may lead to an unprecedented number of individuals moving their retirement savings from tax-deferred accounts (401ks and Traditional IRAs) to tax-free accounts (Roth IRAs). So, what are these new changes? And how can these changes benefit you as a taxpayer? In order to answer these questions, we need to start with a discussion of the differences between the two types of accounts.
401ks and Traditional IRAs vs. Roth IRAs
When most people think of “retirement accounts”, they think of their 401k plan at work or their self-funded traditional IRAs. The benefit of these plans is simple – any amount you put away for retirement is subtracted from your taxable income and reduces your tax bill. As an added bonus, you don’t pay taxes on the earnings in these accounts until you retire and start taking withdrawals. But you haven’t completely escaped the tax man with these accounts, because when you do pull the money out, you will be taxed on everything you withdraw – your original contribution plus any earnings the accounts have accumulated over time. That puts these types of retirement accounts into the category called “tax-deferred” accounts, meaning you defer paying the taxes on the money until a later date.
There is another type of retirement account that you may have heard of – the Roth IRA. The difference with these accounts is that any contributions you make are with post-tax dollars. You don’t get any reduction in your taxable income so you don’t pay any less in taxes when you contribute. So what’s the benefit of the Roth IRA? With a Roth account, you don’t pay any taxes when you withdraw your money at retirement. If you contribute $5,000 and that balance grows to $20,000 over the years, you can withdraw the full $20,000 and never pay any taxes on the $15,000 of income the account has accumulated. So, instead of tax-deferred income, you have earned income tax-free.
Prior to 2010, the IRS has allowed certain taxpayers (those with Adjusted Gross Income of less than $100,000) to convert their 401k or traditional IRA to a Roth IRA and pay the taxes in the year of conversion. For instance, if you had $50,000 in a traditional IRA, and your AGI was low enough, you could move that money into a Roth IRA and pay taxes on the $50,000 with the hope that the account would continue to grow and earn money tax-free over the years until you retired.
New Law for 2010
This all leads to our first question – What is the new tax law change? Beginning in 2010 the AGI limit for conversions has been eliminated, which means that all taxpayers are eligible to convert their 401k or traditional IRA into a Roth. On top of that, if you make a conversion in 2010, the IRS will allow you to delay the payment of the taxes on the conversion until 2011 and 2012. Both of these changes have made Roth conversions a more attractive option for many taxpayers.
Who Should Convert?
So, what type of taxpayer would benefit from a Roth conversion? Unfortunately, as with most tax planning strategies, the answer isn’t easy and it requires a few assumptions made about the future. But there are some specific circumstances where a conversion can make a lot of sense. Let’s look at a few of those instances:
- Young taxpayers with money available outside of their retirement accounts to pay the taxes: Since earnings in Roth IRA accounts are tax-free, it makes sense that the longer the investments have to earn income, the more attractive the Roth accounts become. But, in order to receive the full benefit of this longer timeframe, the taxes paid on the conversion should be paid from funds outside of the retirement accounts.
- Taxpayers who expect to pay a higher tax rate in retirement: If you believe that you will be in a higher tax bracket when you retire than you are now, it makes sense to convert and pay taxes at your current, lower rate. Unfortunately, predicting future tax rates is extremely difficult, even more so for taxpayers with many years until retirement. It is important to keep in mind that most people underestimate the amount of money they will want or need in retirement, and thus a lot of people mistakenly believe that their tax bracket will be lower in retirement. That is not always the case.
- Taxpayers who expect to collect Social Security benefits in retirement: One of the ugly truths of the tax code is that Social Security benefits are potentially taxable. If you have significant income from other sources, up to 85% of your Social Security benefits may be subject to income tax. Distributions from 401ks and traditional IRAs are included in the calculation of “other income”, but Roth IRA distributions are not included. So, in addition to paying no tax on your withdrawals from your Roth account, you may be able to escape the additional tax on your Social Security benefits.
- Taxpayers with low taxable income in 2010 (or 2011 or 2012): If you expect that your 2010 income will be unusually low due to a job change, a large deduction, or some other unusual circumstance, it could make sense to convert to a Roth IRA to take advantage of a lower tax rate. You may even be in a position where you are in danger of losing valuable deductions unless you create other income. If this is the case, it might be possible to convert to a Roth IRA and pay no taxes on the conversion.
- Taxpayers with business losses or other loss carryforwards: Some business owners may find that their expenses exceed their revenues during 2010. Others may have losses from prior years that they were unable to use that have been carried forward to 2010. With a Roth conversion, these taxpayers could take advantage of these excess losses and end up paying little or no taxes.
- Taxpayers who want to avoid required minimum distributions: With traditional IRAs, you are required to start taking distributions when you reach the age of 70 ½, even if you don’t need the money. Roth IRAs, on the other hand, have no such requirement. So, for taxpayers who have the resources to pay for retirement without the need to dip into their IRA, a Roth conversion can eliminate the often confusing and unnecessary expense of required minimum distributions.
- Taxpayers who want to provide a tax-free source of income to their children: For many people, their retirement account is not only a way to pay for their expenses in retirement, but it is also a vehicle for leaving a legacy to their heirs. While the beneficiaries of traditional IRAs must pay taxes when they take distributions, the tax-free status of a Roth IRA never changes. That means your children (or grandchildren or great-grandchildren) will never have to worry about the tax consequences of the distributions they take from their inherited Roth IRA accounts.
There are two important things to keep in mind when making the decision:
- The decision is not “all-or-nothing”. You can convert as little or as much of your 401k or traditional IRA as you want. This allows you to maximize the tax benefit of a conversion.
- The decision is revocable. You have until the due date of your 2010 tax return to reverse your decision and restore your retirement accounts to their original states. So, if you make a conversion and the value of the account goes down, or if you feel like you are no longer able to pay the taxes, you have plenty of time to change your mind.
As you can see, the decision of whether to convert or not convert is not easy, and it involves a lot of calculations and some guesswork. Although the elimination of the $100,000 AGI limit is permanent, the election to pay the taxes over two years is only good for 2010 conversions, so now is the time to see if a conversion is right for you. With a good understanding of the new tax law, and with the help of a qualified accountant, it is possible for you to use this new tax law to your advantage and maximize the money you will have available for retirement.
Additional reading:
7 Steps to a 2010 ROTH IRA Conversion
2010 ROTH Conversions: Look Before You Leap