Many clients are already looking ahead to 2010 when two much ballyhooed tax law changes concerning traditional-to-Roth individual retirement account conversions will occur.
These are the removal of the current income cap; and the ability to defer payment of income tax.
“Many people would like to do a Roth conversion because of the favorable income tax treatment on distributions,” says Daniel Cordoba, CEO of Asset Exchange Strategies, LLC, Austin, Tex., and founder of the National Association of Tax Favorable Investing.
“There’s an expectation that tax rates in the future will be higher. For clients concerned about paying excessive taxes later on, a Roth can be a good hedging strategy.”
How so? While funds invested in a traditional IRA grow tax-deferred, distributions from a Roth IRA are income tax-free once clients are eligible to begin taking withdrawals at age of 59 1/2 and after the owner has held the Roth for five years.
Also to be considered, however, is the tax treatment of account contributions. Funds contributed to a traditional IRA are income tax-deductible; Roth IRA account holders do not enjoy the same advantage.
Many high-wage earners, sources say, are now expressing interest in doing a traditional-to-Roth conversion because of the lifting of the $100,000 modified adjusted gross income limit on such conversions in 2010. Those who earn less than the $100,000 cap can convert now–and they may want to do so. Given still depressed equity prices, clients may pay less income tax on an IRA account value that stands to grow with market appreciation, experts point out.
Clients who do convert in 2010 can defer recognizing of income over the next two years. The IRS thus will allow individuals to pay 50% of the tax on conversion in 2011 and the balance in 2012.
For individuals at or near retirement, a key issue is the impact of a conversion on income planning. The transaction may or may not make sense, sources say, depending on whether the client intends to draw down the account or keep funds invested.
“A traditional-to-Roth IRA conversion should be considered by clients who don’t need to tap retirement assets immediately,” says Gary Tenpenny, a senior financial planner for Mid American Financial Group, Overland Park, Kan. “By keeping the money in the account, clients will achieve greater flexibility in later years when they do need to draw on additional income sources.
“A conversion will be optimal for people who are between five and 10 years of retirement,” he adds. “They can let the time value of money [invested] go to work for them.”