Beginning in 2005, a little-known change in the tax law will allow more people, primarily older and wealthier retirees, to take advantage of moving funds from their traditional IRA to a Roth IRA.
For many, a Roth IRA is preferable to a traditional IRA, primarily because of the tax-free earnings on distributions if the Roth IRA is established for at least five years and the distributions are taken after age 59 1/2. But they are also beneficial if you think that you will be in a higher income tax bracket in future years. Additionally, if you have earned income, Roth IRA contributions can be made indefinitely, regardless of age. One of the most attractive features of a Roth IRA, unlike a regular IRA, is the fact that there are no required minimum distributions once you reach age 70 1/2.
And this is where the new law change takes effect. Most retirees fund their Roth IRA by moving (converting) funds from their traditional IRA to their Roth IRA. A conversion isn't allowed if modified adjusted gross income (basically your taxable income less any amounts that you are converting from an IRA to a Roth IRA) is greater than $100,000. This threshold is the same for all taxpayers regardless of their filing status. Because of this limitation, many who were taking required minimum distributions from their traditional IRAs were finding that those distributions were pushing them over the $100,000 limitation and were then barred from converting those funds to the Roth IRA.
Example: Norma has regular income, such as interest and dividends, of $85,000. She is also required to take a minimum distribution of $20,000 out of her traditional IRA. Under the old rules, she could not make a conversion from her traditional IRA to a Roth IRA because her income exceeded the $100,000 threshold.
But the new law allows you to ignore the amount of the required minimum distribution when computing your threshold income. In 2005, using the example above, Norma would be allowed to make a conversion from her traditional IRA to a Roth IRA since the $20,000 minimum distribution will be not be counted in computing the $100,000 income limitation. Therefore, many older individuals will be able to grow their Roth IRAs by converting traditional IRA funds.
Of course, most funds converted from a traditional IRA to a Roth IRA are treated as taxable income. Because of the taxability of the conversion, some shy away from moving funds from their IRA to a Roth IRA. But this might be shortsighted. It's possible to plan your conversions in years when your income in minimized. And the use of a Roth IRA as part of an overall estate plan can be very powerful, since the Roth IRA funds can pass through to beneficiaries tax-free. Also, since there is no required minimum distribution, the Roth IRA can be passed on and continue to grow tax-free, possibly for decades.
There are even more reasons that you should look into a Roth IRA. For whatever reason, the Roth IRA was a hot-button issue when it was first created in the tax law, but it seems that lately it has been overlooked. Make sure that you understand the Roth IRA provisions, and don't hesitate to fund your Roth IRA if it all makes sense to you.
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