Dec 30, 2009

What You Need to Know About Roth IRAs in 2010

According to a September 29, 2009 Fidelity Investments study, 88% of respondents are unaware of the 2010 Roth conversion opportunity.

The what opportunity?

With only 12% who are aware of this, chances are good you need a crash course in what exactly has changed in 2010 regarding the Roth IRA conversion opportunity and why it matters to you.

What is a Roth IRA

First, let’s start with the basics. I run into quite a few people at my day job who are unaware of what exactly a Roth IRA even is. Most folks have heard of it, but are unsure of how it works. Some of you might be asking, “what is a Roth IRA?” It’s OK, you’re not alone — here’s the basic gist:

A Roth is an Individual Retirement Account that is funded with after-tax contributions; the money grows tax-deferred; and withdrawals are TAX FREE!

Think of it this way — already taxed money goes in and comes out completely free of taxes. It’s a pretty sweet deal if you qualify and meet the specifications. Some of the specifications include income limits and number of years account is opened. Roth IRAs have been around since 1998 and have grown in popularity since.

What is a Roth IRA conversion?

How would you like to take money from a fully-taxable account and put it into an account where it’s tax-free for life?! That’s exactly what a Roth conversion is. It’s simply converting your money from a Traditional IRA to a Roth IRA.

The problem is that whenever you do this you have to pay taxes on the amount you withdraw and convert from your Traditional IRA. (What — you think Uncle Sam would let you off the hook?) So, for example, let’s say you want to convert $10,000 from your Traditional IRA — you would have to tack that 10 G on to your income for the year and pay tax at whatever rate you are at. (It’s as if you earned an additional $10,000 of income.)

What is the opportunity?

There’s been plenty of talk regarding the 2010 Roth conversion opportunity, which is why I’m surprised by the Fidelity study. One big change for 2010 and beyond is that anyone can convert to a Roth regardless of income level. Previously, if you made over $100,000 you could not convert to a Roth. (As a side note, that rule never made sense to me because the IRS would get more in tax revenue from folks who are making more money because they are in a higher tax bracket.)

The opportunity for 2010 is that you have a choice to pay all of your taxes in 2010 or average the taxes owed on the conversion over two years (i.e. pay in 2011 and 2012). It’s not often that the IRS gives you a choice on when you can pay your taxes. (One additional note: 2010 is the last year for the current low income tax rates. The current law plans for higher tax rates in 2011 — so, if you chose to average your tax payments over the two year period in 2011 and 2012, you might get hit with higher tax rates.)

Why does this matter?

This matters because for some individuals who are laid off, not working as much, receiving a lower income, or retired (to name a few scenarios) — this might be a great time to convert your money to a Roth and potentially pay lower taxes than you would normally. Also, although the markets have rebounded significantly, account balances are still off their highs, which means that converting when accounts are low will result in less overall tax being paid. If you get that money into a Roth, all the earnings and growth you receive will be tax free!

Roth IRAs are great retirement tools that are worth a look to see if they make sense for your situation either through regular contributions or through a Roth IRA conversion. Be sure to review the rules and regulations to make sure a Roth IRA conversion is right for you in your quest for retirement.