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New Rules for Roth IRAs Benefit High Income Folks in 2010

People with modified adjusted gross incomes over $100,000 have been ineligible to contribute to Roth IRAs or to convert traditional IRAs to Roths.  That all changes on Jan.1 when those with high income will be able to make the conversion with no restriction on the amount .  Of course, the amount converted will be subject to tax as earned income if it was originally contributed before tax.

This is a real boon for anyone who has after tax contributions in a traditional IRA.  It should be possible to make the conversion to Roth with no tax liability, but only to the extent that the IRA holdings are derived from after tax contributions.  If this could effect you, consult your tax professional.

IRA Holders Are Unaware

According to Howard J. Stock, writing for (here), from 42% to 74% of clients were unaware of the tax law change.  The percentage depended on where the clients were attached, with the lowest percentage with wire house advisors and the highest percentage with bank based advisors.  This is not surprising because the income limits for eligibility eliminate most who have professional advisors have kept Roth IRAs off the radar of many of these people. 

And even advisors say they need help in discussing the changes with clients, according to Stock.  This is a new area for many of them as well.

Complications Under Age 59 1/2

There are complicated rules for those under 59 1/2.  These have been completely and expertly described by Natalie Choate at (here).  It is interesting that, if one converts prior to age 54, the conversion is a way to get money out of a traditional IRA without the 10% penalty for under 59 1/2 withdrawals.  The individual must wait a minimum of five years after the date of conversion.  Thus, a person who makes a conversion at age 45 will be able to make a penalty-free withdrawal after five years, at age 50.  Two caveats:  Read the Choate article carefully and consult your own tax professional. 

Opportunity to Escape a Tax Trap

Investors in Roth IRAs pay income tax on the money they invest now and withdraw it tax-free in the future, the reverse of the traditional IRA structure. Investors will also be able to spread those upfront tax payments over two years.

Until now, high income investors with after-tax contributions to traditional IRAs made years ago, were trapped and could not get the money into a tax advantaged Roth IRA.  All earnings from the traditional IRA are taxable on distribution, as well as all before tax contributions, but earnings and principal distributed from a Roth are not subject to tax.

The tax trap is illustrated in the following example.  Let's consider the hypothetical investor who contributed $50,000 after tax to his traditional IRA between 1988 and 2008,  There are several reasons why this might have occurred.  Common reasons for making after-tax contributions are:

1.  The annual tax deductible contribution limits had been reached;
2.   Income limits for tax deductible contributions were exceeded;
3.   Participation in 401(k) plans had restricted tax deductible contribution eligibility.

This individual will never pay any tax on withdrawal of the $50,000.  However, all earnings within the traditional IRA are taxable upon withdrawal.  If the person is currently 50 years old, by age 70 the value of $50,000 might grow to $200,000.  At age 70 1/2, required minimum distributions must start.  $150,000 of distributions will be taxed.  Actually, more than that amount will be taxable in future years as the account continues to appreciate.

If a Roth conversion is made for the $50,000, the future appreciation will not be subject to tax upon withdrawal.  Furthermore, there are no minimum required distributions exist for Roths, so the entire account can be left undisturbed for as long as desired.    

Disclosure:  The author provides financial planning services but not specific tax advice.  Clients and readers are always advised to consult a tax professional before implementing any strategy that might involve tax liabilities.