Every time Congress changes federal tax law, Baltimore-Washington Financial Advisors analyzes how the new rules might affect our clients. The Pension Protection Act of 2006, signed into law in December, is the latest such tax law change that provides new savings and investment opportunities.
Let’s look at how BWFA considers the impact of just one opportunity created by the Pension Protection Act. In 2010 and beyond, you will be permitted to “convert” funds from a traditional IRA to a Roth IRA, regardless of your income level. Previously, you could do this only if your income was below $100,000. Some high income clients may find the Roth IRA conversion in 2010 very beneficial over the long term—and taking steps today will maximize the benefits.
A Roth Refresher
A Roth IRA is an individual retirement account that has special tax characteristics that are different from a traditional IRA. Contributions to Roth IRAs are always made with money that has already been taxed; in other words, you do not get a tax break for putting money in a Roth IRA. However, you do not pay taxes on withdrawals from a Roth IRA after age 591/2, if you follow certain basic rules.
In contrast, contributions to traditional IRAs can reduce your taxes in the year you make the contributions. But you will be taxed on your investment earnings and on your deductible contributions when you begin to withdraw from a traditional IRA. Therefore, the same amount of money in a traditional IRA will yield less after-tax income for you than a Roth IRA.
You can build up your Roth IRA in two ways, but both ways are currently subject to income restrictions. One way is to make annual contributions to a Roth IRA if your income is below $160,000 for couples, $110,000 for singles. A second way is to “convert” funds from a traditional IRA to a Roth IRA. This means you take money from a traditional IRA, pay the taxes, and move it to a Roth IRA. Currently, you can only do this if your income is below $100,000. Effective in 2010, the income restriction on conversions will disappear.
A Window of Opportunity for High Income Clients
Here is one way you could take advantage of the new savings opportunity. Suppose you and your spouse each make $5,000 non-deductible contributions each year from 2006 through 2010 to traditional IRAs. Non-deductible IRA contributions are available to anyone with earned income and are not phased out at higher income levels. Therefore, you could contribute a total of $50,000 to your traditional IRAs during those years.
In 2010, you could convert all of the money in your traditional IRAs to Roth IRAs. Since your traditional IRAs were funded with non-deductible contributions, you would only pay tax on the earnings. Now you have Roth IRAs that will grow income tax-free for life.
Sweetening the pot just a little more, the government will allow you to spread out your tax payments on the 2010 conversions to the years 2011 and 2012.
Is this Strategy Right for You?
The Roth IRA conversion strategy is not for everyone. If you already have a large IRA which was funded mainly with pre-tax contributions, you will have to pay more taxes to do the conversion. Further analysis would need to be done to determine if this is in your best interest.
Our job as financial advisors is to understand the tax changes that create these types of opportunities, and to bring them to your attention. Together we can discuss whether we have a strategy that works for you.