The Roth individual retirement account (IRA)
has been an attractive retirement savings option since its inception
in 1998. However, income eligibility restrictions have prevented
many higher-income individuals from using this savings vehicle.
Two recent developments are changing that - the removal of income
limitations for Roth IRA conversions and tax laws making the Roth
401(k) permanent.
2010 Roth Conversions
Starting in 2010, all taxpayers, regardless
of the amount of their adjusted gross income (AGI), can convert
from a traditional IRA to a Roth IRA. Before 2010, your AGI cannot
exceed $100,000 to convert, not including any income resulting
from the conversion. Amounts converted must be included in income
if taxable when withdrawn (i.e., contributions and earnings in
deductible IRAs and earnings in nondeductible IRAs) but are exempt
from the 10% early withdrawal penalty.
If you make a conversion in 2010, the tax
can be paid in two installments in 2011 and 2012, with no tax
due in 2010. However, if you prefer, you can elect to pay the
tax in 2010, which may make sense if the current lower tax rates
are not extended beyond 2010 or you expect much higher income
in 2011 or 2012. Taxes on conversions made after 2010 must be
paid in the year of conversion.
Permanent Roth 401(k)s
Originally, Roth 401(k)s were scheduled
to expire in 2010, so many companies were not willing to start
a plan that would expire after a few years. However, the Pension
Protection Act of 2006 made Roth 401(k)s permanent, which should
help spread their use.
The Roth 401(k) is patterned after the Roth
IRA - contributions are made from after-tax earnings that grow
tax free, and qualified distributions are withdrawn tax free.
Employees eligible for their employer's 401(k) plan are also eligible
for the Roth 401(k). There are no income limitations for contributions
to a Roth 401(k), with contribution limits of $16,500 in 2009
plus a $5,500 catch-up contribution for those age 50 and over,
if permitted by the plan. Contributions can be split between a
regular and Roth 401(k), as long as total contributions do not
exceed the maximum. Funds contributed to each type must be held
in separate accounts. Any matching contributions made by the employer
must be held in the regular 401(k) account, so they will be taxable
when withdrawn.
Unlike a Roth IRA, annual distributions
must be taken after age 70 1/2. However, funds in the Roth 401(k) can be rolled
over to a Roth IRA, which would not require distributions during
the owner's lifetime. There is no provision to convert a regular
401(k) to a Roth 401(k).
If you expect your income tax bracket to
be similar or higher during retirement, a Roth 401(k) will typically
result in more retirement funds than a regular 401(k).
Don't Forget about the
Roth IRA
One advantage of the change in the Roth
conversion rules is that it effectively removes the income limitations
for contributions to a Roth IRA starting in 2010. In 2009, single
taxpayers with modified AGI less than $105,000 and married taxpayers
filing jointly with modified AGI less than $166,000 can make contributions,
regardless of their participation in a qualified retirement plan.
Contributions are phased out for single taxpayers with modified
AGI between $105,000 and $120,000 and for married taxpayers filing
jointly with modified AGI between $166,000 and $176,000 in 2009.
Starting in 2010, individuals with income
over the limit can make contributions to a nondeductible traditional
IRA and then immediately convert the balance to a Roth IRA. For
2009, you can contribute to a nondeductible IRA and convert the
balance in 2010. In 2009, you can contribute a maximum of $5,000
with an additional $1,000 catch-up contribution if you are age
50 or older.
Since there are no required minimum distributions
during your lifetime, the Roth IRA is a particularly effective
way to transfer assets to family members. You can allow the Roth
IRA to continue compounding on a tax-free basis during your life,
with no withdrawals. If you leave the Roth IRA to your spouse
after your death, he/she can roll the balance over to his/her
own IRA, so no withdrawals would be required during his/her lifetime.
When your spouse dies, his/her beneficiaries would then have to
take distributions over their life expectancies, but qualified
distributions would be taken free of federal income taxes. By
using this strategy and only taking minimum distributions when
required, the balance can continue to grow on a tax-free basis
for years or even decades.
