The coming year offers a unique opportunity for high earners who want to safeguard their individual retirement account gains from taxes at retirement. The Roth IRA provides that advantage: Deposits are taxed when they go in, but then withdrawals after you retire are tax-free, along with all the appreciation your funds have seen over the years.
Depending on your tax bracket in your earning years, this can look mighty appealing compared with the traditional IRA formula of depositing tax-free now but paying tax later for every dime your IRA earns over your working life.
Roth IRAs can be a great savings option, but previously not everyone could use a Roth. If your adjusted gross income was more than $100,000 (or $176,000 for couples filing jointly), you didn’t qualify to make Roth IRA deposits.
In 2010, a loophole opens up. From this year onward, you can transfer deposits from a traditional IRA into a Roth regardless of income level. High earners still can’t make deposits directly into a Roth IRA, but they can open a traditional IRA, make deposits there and then transfer the funds over. High earners can also transfer any existing IRA deposits into a Roth.
It’s important to note that switching your retirement funds from a traditional IRA to a Roth triggers a tax event. Because Roth funds are taxed at deposit, your transfer amount will be subject to taxes at your current tax rate.
In 2010 only, the IRS gives taxpayers some help with this problem, allowing the tax due to be paid over the following two years. So if your retirement fund transfer into a Roth generates a $10,000 tax bill, you pay none of that in 2010, and $5,000 each in 2011 and 2012. In years after 2010, your tax bill for depositing into the Roth will be due in full that year.
Weigh the decision to transfer funds into a Roth IRA carefully. Switching your tax burden from later to essentially now may be advantageous for some taxpayers but may result in paying more total tax for others. It will help to consider your current earnings and tax situation as well as the earnings and tax base you expect in retirement. Whether you get a benefit from a Roth depends on several factors, including the following:
- Your tax rate now
- Your anticipated tax rate in retirement
- Whether you live in a state with state income tax now
- Whether you plan to retire to a state with state income tax
Here are a couple of scenarios. Let’s say you’re in a high tax bracket now and you live in a state that collects income tax. But you’re planning to have a lower tax rate in retirement and retire to a no-income-tax state. Staying with a traditional IRA may be a better idea because your payouts in retirement will be at a lower tax rate and you’ll pay through the nose for your onetime Roth transfer event now.
On the other hand, let’s say you live in a no-tax state now and fall in a moderate tax bracket but plan to keep your earnings high later in life and move to an income-tax state to enjoy your golden years. In this case, switching to a Roth now probably results in you paying less tax over your lifetime, as you’ll avoid taxes on withdrawals later, including taxes on all of your investment gains.
One final factor to consider: The recent stock market downturn may make 2010 a good year for many to switch their traditional IRA funds to a Roth. Many retirement accounts have shrunken balances now, so the tax due will be less than it would have been just a year or two ago. If the stock market recovers, balances will rise again, translating to more tax owed if you transfer into a Roth in future years.
Business reporter Carol Tice contributes to several national and regional business publications.