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Roth IRAs have been receiving a lot of press lately in the face of recent tax and legislative changes. In fact, our last quarterly newsletter included a notice about Roth IRA conversion modifications beginning January 1, 2010, which remove the income limitations and thereby allow more people access to tax-free retirement money. However, because every investor has their own unique situation, it is important to work closely with your financial advisor to assess the advantages and disadvantages of Roth IRAs. The focus of this newsletter is to provide further insight and background on Roth IRAs, and how they could impact your retirement nest egg.


What is a Roth?

A Roth IRA is a type of individual retirement arrangement created by the government to provide tax benefits for investors saving for retirement.

The Roth designation was established 12 years ago and named for its chief legislative sponsor, the late Senator William Roth of Delaware.

Traditional versus Roth

Contributions to a Traditional IRA are tax deductible and will grow tax-free until you are ready for retirement withdrawals at age 59˝ or older. At this point, the distributions will be taxed as income at your current tax bracket.

Roth IRA contributions are not tax deductible. However, unlike the Traditional IRA, Roth money withdrawn in retirement will not be taxed at all, given you have held it for at least 5 years and are over age 59˝.

Roth IRAs are not subject to the same minimum distribution requirements that Traditional IRAs entail. Therefore, one does not need to begin withdrawals from a Roth at age 70˝ as you would with a Traditional IRA.

It is important to remember that the total annual contribution to Traditional and Roth IRAs is $5,000 (under age 50) and $6,000 (over age 50) for the 2009 and 2010 tax years.

Both Traditional and Roth IRAs offer tax-advantaged growth. However, while Traditional IRA savings are tax-deferred, Roth IRA savings are tax-exempt.



Roth Conversions

Since the introduction of Roth IRAs in 1998, higher-income earners (over $100,000) have been ineligible to convert. However, this restriction will be permanently removed beginning January 1, 2010. Furthermore, in 2010 only, the reported taxable income amount can be spread equally over the 2011 and 2012 tax returns. Most IRAs (Traditional, Rollover, SIMPLE, and SEP) and other qualified plans are eligible for the conversion.

The decision to convert to a Roth IRA depends significantly on your current and expected tax rates. In general, Roth contributions or conversions should be made when your tax rate is low now and higher later. Traditional retirement accounts are optimal when you expect the reverse to be true.

If your situation changes after you have converted to a Roth IRA, you can “undo” the conversion under the Roth recharacterization rules. This decision must be made by the due date of the tax return. Speak with your financial advisor for more details on recharacterizations.

Pros and Cons

The pros of Roth IRAs are easily summarized: tax-free income with no required distributions. Withdrawals from contributions are tax- and penalty-free as long as they are made by the due date of the year in which they were contributed. Given the Roth IRA has been held for at least 5 years and you are over age 59˝, the 10% early withdrawal fee will be avoided, and the withdrawals on earnings will be entirely tax-free.

The main drawback of a Roth conversion is the need to pay taxes sooner and typically in larger sums than would otherwise be necessary with a Traditional IRA. While conversions will be available to higher-income earners as of 2010, contributions may not be allowed if their income is too high.

Conclusion

Roth IRAs are another tool available to you as an investor. While the benefits seem plentiful, Roth IRAs may not be the optimal choice for your particular retirement plan. Be sure to work closely with your financial advisor when weighing the pros and cons of Roth IRAs. Read below for answers to some common Roth conversion questions.

Sources:
1. IRS.gov

The information provided is general in nature and should not be construed as a solicitation, recommendation, legal or tax advice. The information supplied may not be accurate, complete or timely. Laws of a particular state or which may be applicable to a particular situation may affect this information. Tax laws and regulations are complex and subject to change. Always consult with an attorney or tax professional regarding your specific legal or tax situation.