Savvy planner readies for 2010 IRA rule changes

Gerald is a 63-year-old physician who, for many years, channeled money into a traditional 401(k), which he recently rolled over into a traditional IRA when he left his hospital position to start his own practice. The tax-deferred contributions seemed like a good idea at the time, but he has no intention of retiring within the next decade. Thus, he’s bothered by the account’s required minimum distributions (RMDs), which he’ll have to start taking after he turns age 70½. When he mentions this to his financial advisor, some great IRA news comes to light.

His advisor explains that Gerald may be a good candidate for a Roth IRA. Of course, under current law, his modified adjusted gross income (MAGI), which is over $100,000, disqualifies him from converting his traditional IRA to a Roth. But, beginning in 2010, that MAGI limit is no more and virtually anyone can convert.

Why Convert?

As mentioned, among the chief reasons Gerald should consider converting is to avoid the RMDs that would force him to begin depleting his retirement funds before he’s ready to retire. Leaving these funds in a Roth IRA will give them more time to grow — income-tax free.

Another good reason to convert is, oddly enough, precisely the opposite — withdrawals from a Roth IRA can be more attractive than withdrawals from a traditional IRA. Unlike traditional IRA contributions, Roth contributions (along with any funds put in the account via a conversion) can be withdrawn at will with no taxes or early-withdrawal penalties. In addition, withdrawals of Roth IRA earnings will be tax- and penalty-free as long as the account owner is at least 59½ years old and has owned the account for five years. (Early withdrawals of Roth IRA earnings may be subject to taxes and penalties, though some exceptions apply.)

Is There A Cost?

There is a tax cost for converting a traditional IRA to a Roth. Namely, Gerald will be taxed on the amount he converts from the traditional IRA because he’s basically moving assets from an account funded with tax-deferred contributions (the traditional) to one funded with after-tax dollars (the Roth).

His advisor mentions that, for 2010 conversions, the law allows Gerald to report the income evenly over the following two years. That is, he’ll report 50% in 2011 and 50% in 2012. In doing so, he’ll be able to defer recognition of the income and perhaps avoid being taxed at a higher rate. On the other hand, should Gerald’s tax situation warrant doing so, he can elect to report all of the income in 2010.

Is It January Yet?

Naturally, if Gerald is serious about a Roth conversion, there are a number of other details he and his advisor will have to work out. Nonetheless, Gerald leaves his financial advisor’s office with one more reason to look forward to the new year.

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