Just when you think you have your financial plan figured out, it seems like somebody always changes all the rules, forcing you to start all over again.
Once you've sorted out your retirement strategy and figured out which investing vehicles best fit your needs, you still have to decide what type of account you want. Aside from a standard taxable brokerage account, many retirement investors have access to IRAs and employer-sponsored retirement plans as vehicles for their savings. These accounts let you deduct your contributions from your current taxable income, while deferring any taxation on investment income or capital gains until you start making withdrawals from your retirement account. They're a great deal -- but they might not be the best deal anymore.
Making a good thing even better
When Congress created Roth IRAs in 1998, they gave retirement savers the opportunity to pay absolutely no income tax on investment income and capital gains throughout their lifetimes, and potentially beyond. Although you don't get a tax deduction when you contribute to a Roth IRA, if you follow the rules, none of the money you withdraw from a Roth IRA will be subject to income tax. Recent changes in the law now allow employers to set up Roth 401(k) retirement plans for their workers.
In addition to allowing investors to set up new Roth IRA accounts, the original law also made it possible to convert existing traditional IRA accounts into Roth IRAs. Since your IRA contributions earned you a tax deduction, the law makes you pay income tax immediately on the amount converted. However, that's the last income tax you may ever have to pay on the account; from then on, the account is treated as a tax-free Roth. After all, if you end up making big profits on stocks like Google
Opening the doors
Unfortunately, the original law didn't allow taxpayers earning $100,000 or more to convert their IRAs to Roth IRAs. As a result, many high-income people with large retirement plan balances were unable to convert. However, in May, a new law opened up Roth conversions to everyone, beginning in 2010. This will be many investors' first opportunity to participate in Roth IRAs.
The new law also allows investors who convert their IRAs to Roth IRAs in 2010 to delay paying tax on the converted amounts. For instance, if you convert an IRA worth $50,000 in 2010, the old rules would have required you to include the full $50,000 on your 2010 tax return. However, the new law gives you the option of putting off the impact of the conversion, so that you may instead choose to include $25,000 on your 2011 return and $25,000 on your 2012 return.
Is the Roth right for you?
A number of calculators, including one right here at the Fool, let you analyze whether it makes sense for you to convert your existing traditional IRA to a Roth. In general, the question comes down to whether you'd pay more taxes to convert the account than you would save on subsequent tax-free withdrawals. For the most part, if you're in a much lower tax bracket now than you expect to occupy during retirement, you should go ahead and convert. On the other hand, if you pay high taxes now, it might make sense to wait.
However, if you have a large enough net worth to have potential estate tax liability, the nature of the calculations changes dramatically. The entire value of an IRA is included in a person's gross estate and is subject to estate tax, even though that person's beneficiaries will have to pay income tax on the amounts they withdraw. However, if the person converts the account before they die, the income tax created by the conversion also reduces the person's gross estate and the resulting estate tax liability.
Also, while investors with traditional IRAs must start withdrawing money from their accounts at age 70 1/2, there is no such requirement for Roth IRAs. Roth IRAs also make it easier to transfer more money to beneficiaries, while avoiding the tax burden of inherited traditional IRAs.
Of course, 2010 is a long way off. By then, Congressional and presidential elections may have substantially changed the environment for tax and estate-planning legislation, and the provisions currently slated to take effect may well not survive, or may be dramatically altered. On the other hand, if many wealthy people choose to convert large amounts of retirement assets, the resulting temporary rise in tax revenue should appeal to members of both parties. For the moment, the opening of Roth conversions to all presents an opportunity worth considering.
Consult the Fool's IRA Center for basic information on eligibility, account options, and setting up your account. For even more Foolish advice for your golden years, try Robert Brokamp's Motley Fool Rule Your Retirement newsletter free for 30 days.
Fool contributor Dan Caplinger hasn't made any Roth IRA conversions yet, but he figures that it's just a matter of time. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy needs no changing.