What next year's tax law changes regarding IRAs mean for retirement

By Reed Richardson

Typically, the arrival of each new year brings with it a host of tax law changes, some small, some large, and some too arcane for all but the most savvy investors to benefit from. But 2010 brings with it such an important and relatively simple (but easily overlooked) tax law change-one that could potentially save you hundreds of thousands, if not millions, of dollars over the coming decades-that both individuals and small businesses should start planning for how to take full advantage of it right now.


This big change involves a financial transaction known as Roth IRA conversion. Simply put, this conversion amounts to taking an investor's traditional IRA, which is typically funded with pre-tax dollars but pays out taxable income upon retirement, and changing it to a Roth IRA, which uses current after-tax contributions to eventually pay out tax-free retirement benefits. For many, the attraction of shifting more of one's retirement funds from a standard IRA, which also has strict age and minimum disbursement rules, to an investment vehicle with no future tax liability or age-generated payout requirements, like a Roth IRA, is apparent. But up until now, the IRS had set strict limits upon when and how someone could be eligible to execute a Roth conversion.


"Why would you want to make such a swap? Because you think you or your heirs could end up with more money over the long haul by investing in a Roth instead of a regular IRA," explained New York Times money columnist Ron Lieber in July. Previously, households that had adjusted gross incomes of $100,000 or more were barred from such a swap, a rule that prevented many two-income, middle-class families from participating. But starting in 2010, that ceiling disappears permanently, meaning that anyone of any tax bracket that has a traditional IRA can now convert it to a Roth IRA-a process that simply involves catching up on all the unpaid taxes of contributions and investment returns. Even more enticing to those contemplating conversion: the new rule also includes a provision allowing investors to spread that catching up process over two tax years-2011 and 2012-rather than have to take the hit all in one year.


For younger small business owners who expect to be in a higher tax bracket during retirement than they are now, converting that rollover IRA from a previous job's 401(k) could prove to be quite lucrative. And the sooner you convert, the better. Even investors near to retirement could get a bigger bang for the their retirement buck if they're able to cover the cost through non-retirement investments that don't trigger high capital gains taxes. In that same column, however, the +Times+'s Lieber pointed out that some financial experts believe Roth IRAs are just too good to be true and that their tax-free payout status will one day be compromised. As a result, he warns against putting all of one's retirement eggs into the Roth basket. But to get a sense of the tradeoffs and to see if a Roth IRA conversion might best suit your particular circumstances, you can check out the handy one line calculator at http://www.money-zine.com/Calculators/Retirement-Calculators/Roth-vs.-Traditional-IRA-Funds-Calculator/.


Another important advantage of the newly relaxed conversion rules centers on Roth IRA participation. High-income earners-those household making over $160,000 a year-were and still are barred from making any kind of annual Roth IRA contributions. The new no-income limit rule on Roth conversions, however, gives all taxpayers an end-run around this Roth participation cap. Now, any taxpayer can fund a Roth IRA by following a two-step process: First, set up and fund a traditional IRA and then, when it makes sense, convert it to a Roth IRA. If you invest after-tax income to start up the regular IRA, your conversion costs will only involve paying back taxes on the IRA's investment returns, not your contributions. As a result of this loophole, both individuals and small business owners should consider ways they or their companies can establish traditional IRAs in this tax year, so they could then be converted into Roths once 2010 arrives.