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Posted: December 09, 2009

Should the wealthy take advantage of new Roth IRA rules?

It depends....

Gary Wagner and Austin Lewis

This past year has not been an easy one for many Colorado small businesses owners, law partners, corporate executives, and other high-net-worth individuals. The Obama Administration and Congress have proposed a number of new taxes on the wealthy to fund programs ranging from health care to the war in Afghanistan.

While the new tax environment may be daunting, the news is not all bad. Starting next year, many high-income earners will finally be able to take advantage of one tax strategy that previously has been unavailable to them: the Roth IRA.

Created in 1997, the Roth IRA offers many advantages over the traditional IRA, including tax exempt growth and tax-free distributions, no minimum distribution requirements, and enhanced flexibility during retirement.

Currently, individuals with an adjusted gross income of less than $100,000 may convert funds in a traditional IRA to a Roth IRA if they pay ordinary income tax on the conversion amount. But starting in 2010, the income limitation for a Roth conversion will be repealed, making everyone eligible.

With these new rules in place, many high-income earners are asking themselves whether they are good candidates to convert their traditional IRA to a Roth IRA. As with many complicated tax issues, the answer is a definitive "it depends."

Generally, one of the most important factors in determining whether an investor should convert a traditional IRA is their expectation about future tax rates. If you expect your marginal tax rate to increase between now and your retirement, you may be a good candidate for a Roth conversion. Conversely, if you expect your marginal tax rate to be lower in the future, you may not be a good candidate.

Given the current economic and tax environments, many high-income earners expect that their marginal tax rate will only increase in the foreseeable future, which makes them good candidates for a conversion.

It is important to understand the specific benefits and consequences of a conversion, which is why we highly recommend working closely with a financial advisor or a CPA prior to making any decisions. Without question, the complex conversion process is not for everyone and there are many pitfalls to be avoided.

For example, if you decide to convert your traditional IRA to a Roth, you need to have cash available outside the IRA to pay the taxes on the conversion amount, which is usually considered ordinary income. If you are under age 59 ½ and you attempt to use IRA funds to pay the tax, the IRS may consider it an early distribution subject to a ten percent penalty. And even if you are older than 59 ½, the financial advantages of the conversion quickly disappear if you deplete your IRA. And it is important to keep the converted funds in a separate Roth IRA account if you later decide to reverse the conversion.

Finally, you can choose to pay the entire conversion tax bill in 2010, or you can choose to split the tax liability in equal amounts in 2011 and 2012. Because it is difficult to predict what the tax brackets will be in 2011 and 2012, it may be wise to pay the entire tax in 2010.

There are several strategies you can employ to maximize the benefit from the conversion. One strategy is a partial conversion, which means you convert just enough to increase your income to the top of your current tax bracket. This prevents you from inadvertently bumping into a higher bracket. You can then repeat this strategy over a number of years.

Another interesting strategy for high-income earners is to make non-deductible contributions to a traditional IRA each year and then immediately convert that amount into a Roth IRA. By using this strategy, you can build a Roth IRA over a period of time - something that was previously impossible for a high-income earner.

It is critical to understand that a Roth conversion may impact a host of other tax issues, which is why we recommend consulting with a financial advisor or CPA. For example, a Roth conversion may impact your ability to take itemized deductions in the conversion year. For those drawing Social Security, the taxation of your benefits and Medicare Part B premium may increase.

Finally, if you decide that you made a mistake by converting a traditional IRA to a Roth IRA, fear not. The IRS gives you a period of time to effectively take a "mulligan" and reverse the conversion with no consequences. Called a "re-characterization," this strategy may also be helpful if the value of the converted assets go down in value during the conversion year. In this scenario, an investor could re-characterize the conversion, recapture the tax, then complete a new conversion in the following year and pay taxes on the lower asset values.

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Gary Wagner and Austin Lewis, CFP®, are financial advisors at Wagner Wealth Management, a private wealth management firm located in Cherry Creek.

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