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Roth or traditional?

The Taxpayer Relief Act of 1997 introduced a new Individual Retirement Account (IRA) called the Roth IRA. The primary inducement to make contributions to the new Roth IRA is that distributions are tax-free if certain conditions are met. One drawback to it is that contributions to the account are never deductible. Passage of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) in 2001 provided for increased contributions going forward.

For 2010, you may contribute up to $5,000 to a Roth IRA (less any contribution made to a traditional IRA). In addition, EGTRRA established a catch-up provision: People who become 50 or older during the tax year may fund an additional $1,000.

Contributions to Roth IRAs are not deductible and must be made in cash. In addition, unlike regular IRAs, there is no age restriction on contributions. The Adjusted Gross Income (AGI) threshold for contributing to a Roth IRA is $105,000 for single individuals and $167,000 for married couples filing a joint return.

For single filers, the allowed contribution is phased out for AGIs between $105,000 and $120,000. For married individuals, the allowed amount is reduced proportionately if AGI is between $167,000 and $177,000. No Roth IRA contributions are allowed if an individual is married and files separately.

The earnings attributable to contributions accumulate on a tax-deferred basis and become tax-free and penalty free upon withdrawal provided the Roth IRA has been in effect for at least five years and the taxpayer:

* Has attained age 591/2

* Dies or becomes disabled

* Is a "qualified first-time home buyer" using the distribution in the purchase of a primary residence

Distributions from a Roth IRA that has been in effect for at least five years and taken for any of the above reasons are known as "qualified distributions." These are not includible in taxable income.

Now for the tricky part: Distributions taken from Roth IRAs before any of the events specified above are met are deemed "nonqualified." They will be taxable and potentially exposed to the 10% penalty to the extent the distribution includes earnings. For people with disabilities, the 10% early-withdrawal penalty is waived.

Unlike traditional IRAs, there is no requirement to begin distributions from a Roth IRA at age 70%. You can continue to defer tax on Roth IRA earnings your entire lifetime. The traditional IRA's required minimum distribution rules do apply to the beneficiary of a Roth IRA following the death of the Roth's participant. Thus, a beneficiary can continue to defer tax on Roth IRA earnings, but he/she is subject to minimum distribution requirements.

A traditional IRA may roll over (or simply convert) all or part of the assets into a Roth. Withdrawals from a traditional IRA that are converted into a Roth IRA are not subject to the 10% penalty tax. However, the full amount of the conversion may be subject to taxation.


In deciding whether to contribute to a traditional or Roth IRA, take into account a number of factors. Some of these are:

* Eligibility to make contributions

* The number of years to accumulate earnings

* The time projected to begin distributions

* Current versus future tax brackets

Taxpayers must consider whether the current deduction of contributions to a traditional IRA is more valuable than the future recovery of earnings tax-free. I like the idea of tax-free earnings for those of us with disabilities for many reasons. Consult your advisor regarding these decisions.

Convert--or Not?

This is a perplexing question many investors are asking themselves in the wake of all the new tax laws. If the opportunity is available, should you take a distribution from an existing IRA and roll it over (i.e., convert it) to a Roth IRA? A good question--but, not so fast! The first question should be, "Can I convert to a Roth IRA?"

For calendar years before 2010, eligibility to convert from a traditional IRA to a Roth is limited to people with an AGI of less than $100,000--single filers and married filing jointly. This limit will be eliminated in 2010. When computing the $100,000 threshold, the amount converted and the required minimum distributions are not included in countable income.

Beginning in 2010 and thereafter, the $100,000 conversion threshold has been eliminated. In addition, for those converting in 2010 only, 50% of the conversion income will be included on the 2011 income tax return and 50% for 2012. If this election is made, no conversion income is included in the tax return for 2010.

Taxpayers must affirmatively elect out of the two-year spread of the 2010 conversion income to 2011 and 2012. The spread of 2010 conversion income only applies to conversions made in 2010, and not in later years.

Taxpayers should attempt to project their income levels for 2011 and 2012 to determine if electing out of the two-year spread makes sense for them. If so, all the conversion income will be recognized on their 2010 income tax returns.

Those who desired to convert to a Roth IRA in 2009 but who are excluded from even considering a Roth conversion due to the $100,000 AGI limitation and have the ability to do so are likely to manipulate their compensation to fit under the current $100,000 limit. An example of this strategy might be as simple as deferring a bonus into the following tax year or as complex as restructuring contract agreements. Regardless, the availability of a Roth conversion must be confirmed before evaluating the considerations relative to the alternative IRA strategies.

Okay. Let's say the income limits of the Roth IRA conversion are no problem. What are some of the considerations in comparing a traditional IRA to a Roth IRA? Conventional wisdom suggests most taxpayers expect to be in a lower tax bracket when they retire. Financial planning based on this assumption would advise an individual to defer taxes to the greatest extent possible during working years, and ultimately pay the tax bill during retirement at a lower individual rate. Using this logic, converting to the Roth IRA would appear to be a less attractive strategy with taxes paid sooner, based on the individual's current tax bracket.

These days, many people are asking, "Will I really be in a lower tax bracket in retirement?" Some important issues include the following:

* What is the likelihood of higher marginal tax rates in the future?

* Will current deductions for dependents, business expenses, and/or mortgage interest offset less income in retirement?

* Will the individual continue to work in retirement, or will he/she even need the income?

* Is the IRA's objective to accumulate assets for heirs?

Evaluating the tax impact of the Roth versus the traditional IRA depends on the assumptions made. Another consideration is whether the account owner will be subject to the estate tax upon death. If the estate tax is an issue, then converting to Roth IRA may make sense in the long run.

Another important consideration in comparing the two alternatives is the manner in which the tax on the distribution from the existing IRA will be paid. For example, a person with a top marginal bracket of 28% is considering rolling over an existing $100,000 IRA to a Roth IRA. When the $100,000 is distributed, the tax due will be $28,000. If the comparison to the existing $100,000 IRA is made with the Roth IRA starting at $72,000 ($100,000 less $28,000), the result will be much different than if the Roth IRA starts even with the traditional IRA at $100,000. In addition, if the $28,000 tax is paid from the amount being converted to a Roth IRA, the 10% premature-withdrawal penalty will apply to that amount. This penalty does not apply if the income tax liability associated with the conversion is paid from sources outside the converted amount.

If the tax is paid from the proceeds of the IRA being converted, a true apples-to-apples comparison would start the Roth IRA at $72,000. However, if the assumption is that the tax will be paid from some other source and the Roth IRA starts out at $100,000, the result will likely favor the Roth IRA. This is true even if a calculation is made to consider the opportunity cost of the dollars being used to pay the $28,000 tax due on the distribution from the original IRA.

Other Considerations

The uncertainty of tax rates in the future makes this comparison increasingly complex. In addition, the age of the individual electing to convert from a traditional IRA to a Roth is important because the advantage of tax-free distributions from the Roth IRA is leveraged by the length of time the dollars have to grow. The advantage of converting to a Roth IRA generally decreases as the age of the individual increases. Another factor is that, while the individual is alive, the Required Minimum Distribution (RMD) rules have no impact on a Roth IRA.

In summary, many variables in the traditional versus Roth equation should be evaluated on a situational basis. No simple formulas spell out a clear decision. Your IRA strategy should be integrated with your overall financial and estate plan to achieve optimal results. For many people, the guidance of a professional financial advisor will be a critical aspect in making the decision that is right for them.

This material was prepared by Raymond James and Dan Jones of Raymond James & Associates, Inc., member New York Stock Exchange/SIPC.

Contact: Daniel C. Jones, Branch Manager/Vice President--Investments, Raymond James & Associates, Inc., 1095 Rydal Road, Jenkintown, PA 19046/215-881-2700, or 401 City Avenue, Suite 700, Bala Cynwyd, PA 19004/610-771-0316/800-657-8969/
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Title Annotation:MONEY talks
Author:Jones, Daniel C.
Publication:PN - Paraplegia News
Geographic Code:1USA
Date:May 1, 2010
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