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June 23, 2009

The One Trillion Dollar Opportunity


No, we are not talking about some new government bail-out program or new health care spending initiative.  We are, however, discussing a huge opportunity for over 13.5 million Americans who have been locked out of one of the best vehicles to save for retirement, the Roth IRA.  

Starting in 2010, everyone will be eligible to convert their traditional IRA to a Roth IRA regardless of their current income.  It is estimated that the amount that will become eligible to convert a Roth IRA will exceed one trillion dollars! 

The main advantage of a Roth conversion is that you pay income tax on the amount transferred once and you are done.  You never have to pay income tax on the gains or withdrawals from the Roth IRA again (provided you meet the 5 year holding period).  It is one and done.

By way of background, the Roth IRA came into existence in 1997 as an alternative to traditional IRAs.  While traditional IRA contributions are tax deductible, Roth IRAs are not.  Earnings in both are tax deferred, but the real difference is that withdrawals from Roth IRAs are tax free while withdrawals from traditional IRAs are subject to income tax.  Additionally, traditional IRAs require a minimum withdrawal amount beginning in the year that you turn age 70½.  Roth IRAs do not have that requirement.

Roth IRAs give participants the ability to invest in nearly anything they want without having to pay income taxes.  In 2009, only those with incomes below $120,000 for singles and $176,000 for married couples can contribute to a Roth IRA.  For those who have a traditional IRA and would like to convert to a Roth IRA, the income limit is $100,000.  But, and it’s a big but, the conversion limit disappears in 2010.  Virtually everyone can convert part or all of their traditional IRA to a Roth starting on January 1, 2010.

While converting to a Roth IRA means one and done for income tax purposes, there are some issues you must be aware of before jumping in.  First, among these is the fact that you will be required to pay income tax on any amounts transferred from the traditional IRA to the Roth IRA.  For example, if you converted a traditional IRA with a value of $100,000 into a Roth IRA, you would be required to pay tax on the $100,000 conversion amount.  If you were in a 25% tax bracket, that amount would be $25,000 in additional taxes in 2010.

Second, special privileges apply to Roth conversions that are completed in 2010.  In that year, you have an option to pay the tax one of two ways… all upfront in 2010, or deferred… split 50% in 2011 and 50% in 2012.  Any year thereafter, the tax will be due the year the transfer is made.  The gamble here is whether or not taxes will go up or down in 2011 and 2012.  If they stay the same or go down, deferring the tax payment to 2011 and 2012 makes sense.  If they go up, paying all the tax in 2010 is the wise choice.  The decision as to how to pay the tax must be made before the end of the 2010 tax year.

Many Americans believe that taxes will likely be higher in the years ahead.  In such a case, Roth conversions make a great deal of sense.  However, if taxes decrease, or if you find yourself in a substantially lower tax bracket in the future, staying in a traditional IRA might be the better choice.  Since none of us has a crystal ball, many Americans plan to split up their traditional IRA, rolling over a portion of it into a Roth IRA, and keeping a portion in the traditional plan.

A strategy that is gaining popularity is rolling over a portion of one’s 401k assets into an IRA with the idea of converting it to a Roth IRA in 2010.  A different back door strategy with Roth IRAs is to make annual contributions into a traditional IRA with the idea of converting to a Roth at a later date.  This idea is especially popular for those whose IRA contributions do not qualify for the tax deduction, and their income is too high to qualify for a Roth IRA based on annual income limits.  If you convert a traditional IRA where all your contributions were made with after-tax dollars, then only the interest gained in the IRA would be subject to tax in the year of the conversion to the Roth.  There are currently no rules against making annual IRA deposits every year and then converting it to a Roth IRA.

Another difference with the Roth IRA is that it is not subject to “double taxation” at death like the traditional IRA.  For example, suppose you had an IRA with a value of $500,000 at the time of your death.  The $500,000 would be included in your estate for estate tax purposes whether or not your IRA was a Roth or a traditional IRA.  But, after paying estate tax, your traditional IRA would be subject to income tax while your Roth would be income tax exempt.  This is a huge advantage in estate planning.

One last point… with a Roth IRA, you can enjoy a lifetime of tax free income and then leave your Roth IRA to your children or grandchildren and they will not have to pay income tax either.  They can continue receiving monthly tax-free income based on their life expectancy.  You can literally provide tax-free income for decades to come.

2010 Roth conversions provide a unique opportunity.  For most people, it is not a question of whether or not to convert, but rather what percentage should I convert.  This is a big question and it deserves thoughtful analysis and input.  Your Money Concepts’ independent financial advisor is here to help.  We will look at your entire financial picture, helping you put the pieces together.  We will work with you to provide you with the input of ideas and facts so that you can make an informed decision.

Please feel free to pass this on to anyone you feel might benefit.  We appreciate all of your referrals.