IRS Lifts IRA Conversion Cap

Last updated: 8/26/2008 11:37:44 AM

Ask the Expert

My husband and I have not been able to contribute to a Roth IRA because our combined income is over the limit. I read that there are IRS changes coming that may allow us to open a Roth. Can you explain the changes and what they might mean to us?

Your timing is perfect. Beginning in 2010 the IRS will lift the conversion cap on Roth IRAs, allowing workers at any income level to take advantage of a Roth. You can plan ahead for this opportunity by contributing to a nondeductible Traditional IRA for the next two years and converting to a Roth IRA in 2010.

Why Roth?

Unlike Traditional IRAs, Roths aren’t encumbered by minimum distribution requirements. So you won’t be required to start taking money out when you turn 70½. This feature is also a good estate-planning tool. If you don’t need the money in your Roth IRA, you can pass it on to your heirs.

A Roth also helps you manage your tax liability in retirement. Most income sources in retirement are taxable. But qualified withdrawals from a Roth IRA, including earnings, are tax-free. When you retire, you will owe nothing on years of compounded earnings, which may be a significant amount.

How it works

If you earn too much to contribute to a deductible Traditional or Roth IRA, consider making a contribution to a nondeductible IRA (remember to file Form 8606 in the year(s) you contribute). Then in 2010, you can convert some or all of your Traditional IRA funds to a Roth IRA.

When you convert a nondeductible IRA, you will have to pay income tax on the earnings. However, the new conversion rules allow you to spread the taxes over two years. What’s more, if you convert in 2010, you won’t have to pay any taxes on the conversion that year. You can pay half your tax bill in 2011 and the other half in 2012.

Is a conversion right for you?

Roths offer many advantages but may not necessarily save you money.

Things to consider:

Your expected tax bracket in retirement. If you think your tax bracket will fall significantly in retirement, you may be better off leaving your IRA alone and paying the taxes on the money as you withdraw.

How long before you take withdrawals from the converted IRA. In general, the longer you have until you plan to withdraw your earnings tax-free, the better because the earnings will have more time to grow.

How you will pay the tax bill. A conversion makes sense only if you have money outside your IRA to pay the tax bill. If you do take money out of your IRA, you’ll owe income taxes and a 10% penalty if you are not age 59½.

Will you need the money? If you don’t need the money in retirement, the Roth is a good way to pass tax-free earnings on to your heirs.

Member Benefits offers Traditional and Roth IRAs to Wisconsin public school employees and their families.

This is for informational purposes only. Please consult with your tax or financial advisor.

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