If you've been shut out of opening a Roth IRA account, you may finally get your chance -- in a couple of years.
Anyone who has earned income can contribute to a traditional IRA. But Roth IRAs -- which offer the prospect of tax-free income rather than just tax deferral -- have income limits that apply to prevent high-earning taxpayers from creating them. Joint filers who have more than $169,000 in adjusted gross income for 2008 won't be allowed to contribute to a Roth IRA. For singles, the limit is $116,000. For those who make more than that, having a Roth has been an impossible dream.
Getting in through the back door
Even if you're not eligible to open a Roth IRA directly, there's another way in -- by converting a traditional IRA to a Roth. Conversions are actually potentially much more valuable for retirement savers than contributions -- while the maximum annual contribution is $5,000, you can convert your entire IRA balance if you want. But again, income limits apply. If you have gross income of $100,000 or more -- regardless of whether you're married or single -- you can't do a Roth conversion, either.
But that's all set to change in 2010. If the tax laws don't change between now and then, the $100,000 limit on Roth conversions will disappear in 2010, opening the floodgates for anyone who wants to convert their traditional IRAs.
Why does it matter?
At first glance, you might wonder why anyone would want to convert an IRA. While keeping your traditional IRA lets you defer your taxes until you retire, converting to a Roth forces you to pay tax immediately on the amount you convert. The 2010 provisions allow you to spread that amount out over the 2011 and 2012 tax years, but even so, you'll still have to pay tax as a result.
Even though a conversion forces you to pay tax, Roth IRAs have several advantages that may justify a current tax payment. First, while traditional IRAs force you to take minimum distributions shortly after you turn 70, Roth IRAs give you total control to take as little or as much as you want from your accounts throughout your lifetime.
Also, the taxes you pay upon conversion are the last taxes you'll pay on your Roth IRA assets. If you anticipate being in a high tax bracket during retirement -- a reasonable assumption for successful investors with considerable dividend and interest income -- then it can make sense to pay taxes now if you're being taxed at a relatively low rate. With tax rates low by historical standards, it may be best to pay smaller taxes now rather than bigger taxes during retirement.
Asset allocation across accounts
Last, having both traditional and Roth IRA accounts gives you the flexibility to divide your assets in the most appropriate fashion. For instance, investments that don't qualify for lower tax rates on dividends, including REITs like Simon Property Group (NYSE: SPG ) and Equity Residential Properties (NYSE: EQR ) , go well in either type of IRA.
But for dividend-paying stocks with growth potential, such as Coca-Cola (NYSE: KO ) or Wrigley (NYSE: WWY ) , putting them in a traditional IRA means you give up the tax advantages of the 15% maximum rate on dividends. Similarly, investments that have a real chance to grow by huge amounts, including Universal Display (Nasdaq: PANL ) and Middleby (Nasdaq: MIDD ) , are better placed either within a tax-free Roth IRA or in a taxable account that lets investors get the lower 15% capital gains rate.
So if you have money in traditional IRAs and think converting to a Roth might be a smart move for you, 2010 can't come soon enough. And even if you've been locked out of the Roth IRA for more than a decade now, you'll find that it's definitely been worth the wait.
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