WASHINGTON For decades, people planned for retirement anticipating that they would face lower taxes than they paid while working -- but that's no longer a sure thing.
Many people have their retirement savings tucked away in tax-deferred accounts and will have to pay taxes on that money as they take withdrawals. Up to 85 percent of Social Security benefits will be taxed for many of these tax-deferred savers.
And with the federal deficit out of control and the tax cuts enacted in 2001 by President George W. Bush set to expire next year, there's the very real prospect that tax rates going forward will be higher than they were over the last decade.
Enter the Roth Individual Retirement Account.
Created in 1997 tax legislation, Roth IRAs allow workers to put away money that could build tax-free for retirement. Contributions to Roth IRAs do not qualify for tax deductions, but the money that is withdrawn years later, in retirement, is not taxed. That is especially beneficial to younger savers whose accounts have many years to earn interest, dividends and gains that can compound over time. The law that created Roth IRAs also included provisions for allowing taxpayers to convert their existing tax-deferred IRAs into Roths.
But Roth IRAs have had their limits, too. Only taxpayers who earn less than $105,000 ($166,000 for joint filers) in 2009 can contribute the maximum amount ($5,000 per person, with a $1,000 additional catch up contribution for folks 50 or older) to a Roth IRA. And only people earning less than $100,000, single or married filing jointly, can convert their traditional IRAs to Roths.
In 2010, some of those rules will change. That $100,000 limit disappears, so folks with higher incomes can convert traditional IRAs to Roth IRAs. Deciding whether to do that, and how to go about it, is going to be difficult and complex. Here are some considerations.
-- You will have to pay taxes. When you convert a traditional tax-deferred IRA to a Roth IRA, you will pay taxes on all of the tax-deferred money being moved over. If you have been contributing to an account that was fed with nondeductible contributions, it may be hard to figure out how much of what you move will actually be taxable. You can use IRS Form 8606, available on the IRS website (www.irs.gov/pub/irs-pdf/f8606.pdf), to calculate.
For the conversion to make any sense, you need to have enough extra cash available to pay those taxes without having to reduce the size of the IRA to do it.
-- The key to deciding whether to convert comes down to whether you think your taxes on that money will ultimately be higher or lower when it comes time for withdrawal. There are several calculators online that can help you decide if it is a good option. Find one here, and another at Fidelity Investments www.fidelity.com/rothevaluator.
But even after using the calculators, you will have to make your own decision about whether to take the tax-poison now or later. The younger you are, the more likely you are to find that conversion makes sense.
-- A partial decision might be the best one. You can convert a portion of your existing IRA to a Roth IRA, and experts at Fidelity believe this might be the best option for many people. That way you can convert just enough to keep your tax bill low.
-- You can spread out the taxes, too. Just for 2010, if you convert an existing IRA to a Roth IRA, there is the option of paying the resulting tax bill as part of your 2010 income taxes or spreading it over 2011 and 2012. Usually, tax professionals advise people to defer taxes whenever possible. But with the prospects of rates going up in 2011, it might make more sense to be done with the taxes in 2010.
You can also wait and see what happens to your income and tax rates in 2010 and 2011, and then file amended tax returns for those years, switching the IRA taxes from one year to another.
-- You may want to stash more now. You still have 2009 to add to your traditional deductible (or nondeductible) IRA, so that you are in position to convert more funds to a Roth IRA in 2010.
-- You are allowed to change your mind. If you convert your IRA to a Roth early in 2010 and then the market tanks, you may regret having made the conversion. You can get a do-over, reversing the conversion, as long as you act before your taxes are due for the year in which you made the conversion. Then you can reconvert that same money back to a Roth, saving taxes.
To make the best use of that provision, Leon LaBrecque, a Troy, Michigan, financial adviser, suggests creating more than one Roth IRA with different securities in each. That way you could selectively reverse only the conversions of the Roths that lost value. That ultimately is a pretty complex solution that could result in your holding multiple Roth accounts, each with their own account numbers or service fees.
-- You can make the transaction easily. To convert a traditional IRA to a Roth, you don't actually have to move the money or sell any securities. You can simply notify the company holding your IRA -- be it a bank, broker or mutual fund company -- and let them know you want to convert the account, or a portion of it, into a Roth IRA. They will send you the paperwork to do the rest.
(Editing by Maureen Bavdek)