Not many people make New Year’s Resolutions four years in advance, but when President George W. Bush signed the Tax Increase Prevention and Reconciliation Act into law in May 2006, which included a provision to expire the $100,000 modified adjusted gross income (MAGI) limit for Roth IRA conversions in 2010, a lot of savvy folks probably added “Switch to Roth” to their 2010 list.
First a quick word on Roth IRAs or Individual Retirement Accounts. Roth IRAs are similar to traditional IRAs except for one very, very important difference: Traditional IRAs are tax deferred, meaning your contributions aren’t taxed until you withdraw the money. Roth IRAs are tax exempt, meaning you pay taxes on the money you put in, but not the money you take out. Now that’s a lot of italics, and here’s the reason why: Although it seems counter-intuitive to pay taxes now rather than defer, younger investors can use a Roth to take advantage of a long investment time to enjoy tax-free growth while established, more affluent investors should consider rising tax rates. With a growing national deficit, many experts feel that income and capital gains tax rates could rise considerably very soon, and it might make sense to pay taxes on today’s rates and let your investments grow tax free going forward rather than potentially paying taxes at a higher rate in the years to come.
For example, if you convert $100,000 in 2010, you may pay around $25,000 in taxes, but if you wait until after 2010 when the Bush tax cuts expire, your tax rates may rise increasing your tax liability significantly by the time you withdraw. If you convert after 2010, you also risk paying higher taxes at the time of the conversion to a Roth IRA.
The MAGI limit for Roth IRA conversions expire in 2010, and thanks to Congress (a phrase rarely used or uttered), the tax liability from the 2010 conversion can be allocated over 2011 and 2012 unless the tax payer elects not to. For example, if you converted $100,000 in 2010, instead of owing the probable $35,000 for taxes, you could declare $50,000 of income in 2011 and $50,000 in 2012. This one-time benefit is only available in 2010, but you should consider that tax rates are expected to rise in 2011 or 2012, so this might not be the best strategy.
Though the conversion limit for Roth IRAs will expire in 2010, the income restrictions for new contributions still exist, although there is a seldom mentioned loophole. You can set up and contribute to a SEP IRA (IRA for the self-employed) and contribute 25% of your income up to $46,000 and then immediately afterward convert it to a Roth. If you are not self-employed but make more than the MAGI limit to contribute to a Roth IRA, you can contribute to a nondeductible IRA and then roll it over to a Roth IRA If you are going to convert, we suggest that you start saving now for your tax liability. Because no matter what, the taxman’s going to collect his. We just prefer paying a little now rather than more later.
For more information on Roth IRAs or other personal tax strategies, please contact Rita Schooley, CPA at Wendroff & Associates, LLC at 703-553-1099. Also, please look out for our upcoming CEO Roundtable Group this October. To find out more information about joining the group, contact Wendroff CPA Director of Communications Darren Wendroff at 202-596-2891.