There are now some positives to converting a Roth IRA. Starting in 2010, this year, the change in tax rules signed into law by former President Bush take effect. The change will remove the income restriction on conversions which was previously placed at a hundred thousand dollars. Married couples will also benefit under the new regulations, as well. Prior to the rule change, Roth IRAs were available to single filers who earned up to ninety five thousand dollars and married couples earning up to one hundred and fifty thousand.
To review, the difference between a Roth IRA and a traditional IRA is the difference in tax realization. For instance, contributions to a traditional one are tax deductible while they are not for the Roth. Similarly, upon withdrawal, there is a tax event for the traditional while there is none for a Roth. Withdrawals are permitted after reaching the age of fifty nine years and a half. In the case of a Roth, however, they are permitted after a five year lapse.
The tax or lack thereof is at withdrawal is at the crux of the decision making process. This is essential because in a Roth IRA any dividend income, interest income, or appreciation is not taxed. The opposite is true for the traditional type. In converting to a Roth, the investor is assuming that the current tax bracket is low enough to pay the taxes upfront and reap the benefits at a later time. Ideally, one would hope to generate a high return over time tax free.
There is also another benefit in the new legislation. This is the tax deferment option, which is only available for this year. The way it works is that investors who convert to a Roth in 2010 can defer their tax liability over the next two years, 2011 and 2012. This reduces the upfront tax expense. Additionally, their tax liability in those years will be based on their tax bracket in those years not on the 2010 rate. This becomes beneficial if one expects to be in a lower tax band in the future.
There are also some additional benefits to converting to a Roth. As we all know, funds from both types of investments can be used to buy any one of a variety of investments. With the Roth, however, principal contributions can be pulled, after a minimal grace period, without any tax liability. In the case of the traditional IRA, there is a ten percent penalty if funds are taken out prior to the investor reaching the age of fifty nine and a half.
Another important aspect to this year's law change is a built in loop hole. This unique circumstance allows investors to establish a Roth IRA with little to no tax expense. The approach is fairly straightforward. The investor should open up a traditional IRA prior to the April fifteenth deadline for the 2009 tax period. Also, they can make a similar contribution for the present year. Now, by converting from a traditional to a Roth the investor can save taxes. The taxes would be minimal at most given that the investment in the traditional IRA would have occurred very recently.
However, one should keep in mind a few key features. The restrictions that have been changed are only on the conversion and not on initial or new contributions. Those limits are still in place. This means that a high wage earner cannot directly open up a Roth, due to wage restrictions. Other restrictions that have been alleviated, however, relate to married couples. Married individuals can do the conversion as stated before, without wage restrictions. However, if he or she decides to elect for the tax deferment than that choice needs to be followed for all other conversions.
Many have proclaimed this year, 2010, as the year of the Roth IRA conversion. Although there is a lot to be said about that, it is not a material change for most individuals. Furthermore, the tax basis that should be used is the account total at the conversion date. Clearly, if the account value declines then an IRA re-characterization can be applied. At the end of the day, the only thing that has changed are the investor wage limits for conversion.
For additional details on the popular Roth conversions stop by www.themoneyalert.com/2010-Roth-IRA-Conversion.html and if you would like more on the IRA rules you can go here: http://www.themoneyalert.com/IRArules.html for further explanation.