IT MIGHT SOUND LIKE AN OXYMORON, but Congress has come up with a way to raise tax revenues that could save you a bundle in taxes.
Under current law, if your adjusted gross income exceeds $100,000 — on either an individual or joint return — you can’t convert a traditional IRA into a Roth account. But starting in 2010, that restriction disappears. Anyone who makes the switch must pay tax on the money when it is moved to the Roth, rather than paying the piper later when the money is withdrawn from the IRA in retirement.
Why would anyone speed up a tax bill? Because switching to a Roth means all future earnings will be tax free in retirement — rather than being taxed in your top tax bracket, as they would be if you stayed with a traditional IRA. Congress thinks enough investors will rush to the Roth to generate an extra $6.4 billion in tax revenue from 2011 through 2015. Critics complain that this change will actually cost the government billions in lost tax revenue in the long run, when otherwise-taxable funds pour tax free out of Roths. That’s why it could save you a bundle.
In addition to the $100,000 limit for conversions, current law also forbids annual contributions to a Roth IRA if your income is over $110,000 on a single return or $160,000 on a joint return. If the income limits have come between you and a Roth so far, note that you don’t have to wait until 2010 to dip your toes in these tax-favored waters.
This year, you can contribute up to $4,000 to a nondeductible, traditional IRA ($5,000 if you’ll be at least 50 years old by the end of the year; you must have earned income from a job or self-employment to contribute to an IRA). The limits rise to $5,000 and $6,000 a year, respectively, in 2008. That means between now and January 2010, someone age 50 or older can stash $28,000 in a nondeductible IRA. Assume that thanks to good investing, the account grows to $32,000 by 2010. If you convert your IRA to a Roth at that point, you’ll owe tax on just the $4,000 of earnings. So, the price of admission to the Roth will be $1,120, assuming you’re in the 28 percent bracket. And you can pay half the bill in 2012, when you file your 2011 return, and the rest in 2013.
If you have a regular deductible IRA or an IRA created with a rollover from a company retirement plan, things don’t work quite so neatly. The rules demand that you look at all your IRAs together when determining how much of the conversion will be taxed, so you’ll owe more on the switch. That’s not necessarily a bad thing, since you eventually would have had to pay tax on that regular IRA money. But you’ll wind up paying sooner rather than later.
Kevin McCormally is the editorial director of Kiplinger’s Personal Finance magazine. Visit kiplinger.com.
