Thanks to a recent legislative change, there is an opportunity for nearly everyone to benefit from a conversion to a Roth IRA.

The Roth IRA was born on January 1, 1998 as a result of The Taxpayer Relief Act of 1997. It’s named after the late Senator William W. Roth Jr.

The Roth IRA yields no deductions for contributions, but instead provides a benefit that isn’t available for any other form of retirement savings, if you meet certain requirements. All earnings are tax free when you or your beneficiary withdraws the money. Furthermore, unlike a Traditional IRA, you are not required to start withdrawing money at age 70 ½.

Traditional IRAs offer tax-deferred earnings and either tax deductible or nondeductible contributions, depending upon your participation in another retirement plan and your adjusted gross income (“AGI”) in the year for which the contribution applies. (Contributions are generally limited to $4,000 annually for 2007.  For those of you who are 50 years or older, your limit increases to $5,000 for 2007.)

Wouldn’t it be great if you could take advantage of the initial benefits of a Traditional IRA, then switch to a Roth IRA and avoid the taxes on withdrawal?  You can, by making an allowable “conversion” of your IRA account.

Here’s the original law:  Unfortunately, the 1997 tax law that created the Roth IRA contained provisions limiting who could make a conversion. Taxpayers with AGI more than $100,000, whether single or married, were not eligible to make such conversions. In addition, if your AGI was $110,000 or more ($160,000 if married filing jointly), then you were not eligible to make any contributions to a Roth IRA.

The AGI provisions excluded higher income taxpayers from enjoying the benefits of a Roth IRA. They could not convert their traditional IRA to a Roth and could not fund it either.

Of course, those who could make a conversion from a Traditional IRA to a Roth IRA must pay tax on the balance in the IRA account upon its conversion, but only up to the amount on which tax had been deferred.

Now, here’s the good news:  In 2006 President Bush signed into law a tax cut provision that changed the eligibility rules for Roth IRA conversions. Starting in 2010, all taxpayers, regardless of adjusted gross income, will be allowed to convert a traditional IRA to a Roth IRA.  Furthermore, if the conversion is made in 2010, then the income taxes due on the conversion can be spread over two years.  Thus, half of the taxable 2010 conversion amount may be included as taxable income in 2011 and the other half in 2012, helping to spread the tax due.

Conversions in subsequent years (after 2010) are included in income during the tax year in which the conversion is completed. 

The biggest advantage of converting a Traditional account to a Roth is that you “freeze” the taxable amount on the date of the conversion.  In other words, once you pay the tax due on the converted account, you no longer have any taxes to pay. 

For example, let’s say your AGI is approximately $200,000 per year.  You started to fund a Traditional IRA in 2007 and by 2010 you’ve got $20,000 in your account. Suppose further that the account consisted of four years of $4,000 non-deductible contributions – a total of $16,000 in non-deductible contributions - and $4,000 in dividends. If you convert to a Roth IRA account in 2010, you will need to pay income taxes on the $4,000 earnings, spread over the next two tax years. But the good news is you will never have to pay income taxes on this account again, no matter how big it grows until your retirement.   

Most of us have shied away from making non-deductible contributions to an IRA because they are not tax deductible, the investment growth is fully taxable upon withdrawal and withdrawals are subject to minimum distribution rules, yet they offer only a minimal tax shelter (the deferral of tax on the earnings). However, this is no longer the case.  Even non-deductible IRA accounts can be attractive now.  By funding a Traditional IRA between now and 2010, then converting it to a Roth IRA in 2010, you can have your cake and eat it too!

Please feel free to call our office and discuss your situation with one of our Partners.