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Roth IRA door opening just a little to wealthy

New rules end income cap on conversions, but not on contributions.

I get a call about this topic once a year.  I have never had a client convert any major amount of money.  I have had clients convert 3, 4 thousand dollars, but no conversions with any substantial money.

A conversion makes sense for those who anticipate being in a higher tax bracket in retirement than they are today. Typically, that’s younger workers. Tax experts, though, predict that many of us will face higher tax rates in the future given the growing government debt.

It would be my opinion, that tax rates are as low as they will be for a number of upcoming years.  The growing number of federal programs are going to require additional tax revenues.

Convert only if you have money from outside sources to pay the tax bill. You don’t want to pull money out of your traditional IRA, for instance, to pay the tax. Not only would you have less money to put into the Roth, but you would be hit with a 10 percent early withdrawal penalty if you’re younger than 591/2. (You can always convert only a portion of the traditional IRA so the tax bill is something you can afford to pay with other resources.)

Convert if you don’t need to tap the Roth for living expenses in the near future. You want your investments to grow in the Roth as long as possible to make up for the tax hit you take upfront.

Tax experts recommend converting to a Roth if you want to leave the money to heirs. The Roth would be subject to estate taxes, but heirs won’t have to pay income tax on the withdrawals. If you pay taxes upfront at the conversion, that reduces the size of your estate and the amount of estate taxes at your death.

The government next year will eliminate an income cap for those who want to convert a traditional IRA, a 401(k) or other retirement account into a Roth. So, basically, anyone with one of these accounts can open a Roth.

The Roth was created in the late 1990s and has always had income limits on who can directly contribute. That doesn’t change. Full or partial contributions to a Roth can be made this year if your adjusted gross income is less than $120,000 if single and $176,000 for married joint filers.

This has always been a topic of discussion, but not action.  None of my clients have ever wanted to pay the tax on the front end to avoid tax in the future.  Furthermore, anybody with any substantial annual income will be prohibited from converting.  Secondarily, it takes a substantial annual income to save a large amount of money into an IRA.

You will have the option of paying half the tax bill on your 2011 tax return, and the rest on the 2012 return. You will pay tax, though, at whatever rates are in place in 2011 and 2012, so you could end up paying more if Congress raises taxes.

Remember there are only two tax planning strategies, avoid or defer.  Converting from an IRA or 401k to a Roth IRA does not follow either rule.  Converting requires you to pay taxes today, to defer future taxes, that directly violates any tax planning strategy.  However, next year you can defer the tax payment for a year.  You can pay half the conversion tax in 2011, and pay the other half in 2009.

I represent many tax payers who have had to cash in their retirement plans to pay monthly bills.  When you cash in your retirement plan, you have a choice, have taxes withheld or not.  If you did not elect to have taxes withheld, you might owe some taxes.  If you have cashed in your retirement plan and now you owe taxes, contact my office today, 1-877-489-8999.

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