Conversion of Roth IRAs
Introduction
Roth Individual Retirement Accounts (IRAs) are already one of most popular savings vehicles in the United States, and new rules adopted by Congress in May 2006 may make them even more popular. A traditional IRA allows people to set aside a certain amount of money each year that is exempt from the current year's taxes and also is not taxed as it appreciates in value; the taxpayer pays tax only when the money is withdrawn, usually in retirement. With the Roth IRA, introduced in 1998, people must pay the current year's income taxes on their Roth contributions, but they don't have to pay taxes on the earnings when they are withdrawn from the account. Beginning in 2010, people making more than $100,000 per year will be allowed to convert a traditional IRA into a Roth IRA, which may increase the popularity of the Roth IRA.
401(k)s and IRAs
401(k) plans and Individual Retirement Accounts are alike in offering either tax-deferred or tax-free growth of investments. 401(k)s are employment-based. Employers set them up for employees, who can contribute a percentage of their paycheck on a pretax basis, making that portion of their income exempt from the current year's federal income tax. Dividends and capital gains that occur within a 401(k) are also tax-deferred, meaning that no tax is due until the taxpayer begins withdrawing from the plan.
Tax deferral is also one of the main features of a traditional IRA. When a taxpayer contributes to an IRA, they are allowed to take an income tax deduction up to the amount of the contribution (within certain income limitations). As with 401(k) plans, tax on dividends and capital gains earned within a traditional IRA is not due until the taxpayers begins to withdraw the money. Both 401(k)s and traditional IRAs require mandatory withdrawals to begin at age 70.
As of January 1, 2006, federal law also allows for a Roth 401(k). At present, relatively few companies offer this option to employees, but that could change substantially when the rules on Roth IRA conversion change in 2010.
Roth IRA
Roth IRAs differ from traditional IRAs in several important ways. With Roth IRAs, the contributions are not tax deductible, but qualified distributions upon withdrawal are tax-free. Roth IRAs can also offer more flexibility than a traditional IRA. With a Roth IRA, it is not mandatory to begin withdrawing money at age 70; indeed, there is no age limit for keeping money in the account, as long as the person has taxable compensation.
Conversion to Roth IRA
If someone wants to move their money from a traditional IRA into a Roth IRA, they can convert from a traditional to a Roth. This requires paying income taxes on the money being converted. The question for many taxpayers is whether the savings they will realize at a later date when the money is distributed outweigh the taxes they will incur for a conversion. A complicating factor here can be that the additional tax liability at the time of conversion can push the taxpayer into a higher tax bracket. If so, the taxpayer must have sufficient savings to cover the additional taxes, because money from the IRA account cannot be used.
When the $100,000 annual income (modified adjusted gross income or MAGI) limitation for converting a traditional to a Roth IRA is removed in 2010, other rules regulating Roth IRAs will remain. In particular, there will still be rule against contributing to a Roth IRA account if the taxpayer's income is $110,000 or more ($160,000 for couples). It may be, however, that tax planners will find a way around this rule. Taxpayers could open a nondeductible IRA, then convert it to a Roth. In practice, then, after 2010, a taxpayer will be able to obtain a Roth IRA in three different ways: opening a Roth IRA and making yearly contributions; contributing to a Roth 401(k); or by converting a traditional IRA into a Roth and paying any ensuing tax liability.
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