Congress Opens the Door to Roth IRAs to Everyone

It might sound like an oxymoron, but Congress has come up with a way to raise tax revenue that could save you a bundle in taxes over the years. To help pay for this spring's extension of preferential tax rates for dividends and capital gains, lawmakers decided to scrap the income limit that prevents higher-income taxpayers from converting individual retirement accounts to Roth IRAs.Under current law, if your adjusted gross income exceeds $100,000 - on either an individual or joint return - you can't do a traditional IRA to Roth IRA switcheroo. But starting in 2010, that restriction disappears. The change will be a short-term fund-raiser for Uncle Sam because anyone who converts must pay tax on the money when it is moved to the Roth . . . rather than paying that tax later when it is withdrawn from the IRA in retirement.

Why would anyone pay taxes sooner rather than later? Because switching to a Roth means all future earnings will be tax-free in retirement—rather than being taxed in your top tax bracket, as they would be if you stayed with the traditional IRA. Congress thinks the appeal will be strong enough to trigger enough Roth conversions to generate an extra $6.4 billion in tax revenue from 2011 through 2015. Critics complain that this change will actually cost the government billions in lost tax revenue in the future, when withdrawals from unconverted IRAs would otherwise have been taxed. That's why this change could save you a bundle.

It's impossible to know exactly how a conversion would affect you. That depends in part on what happens to tax rates in the future. If rates rise in the future, a conversion would certainly pay off. If rates fall, a conversion could be a mistake because it would mean paying taxes at today's rates to avoid tomorrow's lower levy. But even if rates fall, a conversion can pay off handsomely because of other advantages of the Roth. You never have to make a withdrawal from a Roth, for example, while mandatory payouts are required from traditional IRAs starting at age 70 1/2. The longer the money is allowed to stay in the Roth, the more you'll benefit from the tax shelter. If you're worried about estate taxes, converting to a Roth can actually cut that tab, too. While both traditional and Roth IRA balances will be included in your estate (if there's still an estate tax), the tax you pay on the conversion will be gone, thus reducing the size of your taxable estate.

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And, note this: To encourage you to convert to a Roth in 2010, Congress decided to delay the tax bite by one year and then let you spread the tab over 2011 and 2012.

Get a Head Start on Your Roth

In addition to the $100,000 limit for conversions, the law also prevents Roth contributions if your income is more than $110,000 on a single return or $160,000 on a joint return. If the income limits have come between you and a Roth so far, note that you don't have to wait until 2010 to dip your toes in these tax-favored waters.

This year, you can contribute up to $4,000 to a nondeductible traditional IRA ($5,000 if you'll be at least 50 years old by the end of the year; you must have earned income from a job or self-employment to contribute to an IRA). The limits rise to $5,000 and $6,000 a year, respectively, in 2008. That means between now and the beginning of January 2010, someone age 50 or older can stash $28,000 in a nondeductible IRA. Assume the account grows to $32,000 by 2010, when the $100,000 conversion barricade disappears. If you convert your IRA to a Roth at that point, you'd owe tax on just the $4,000 of earnings. So, the price of admission to the Roth would be $1,120, assuming you're in the 28% bracket. And you'd pay half the bill in 2012 when you file your 2011 return and the rest in 2013. If you're married, both you and your spouse could use this method to create healthy Roths.

Whether it was deliberate or not, by eliminating the income limit on conversions, Congress also effectively obliterated the limit on Roth contributions. As things stand now, starting in 2010, you'll be able to contribute to a nondeductible traditional IRA and immediately convert it to a Roth. Before that happens, though, Congress may either write rules to block this maneuver . . . or drop the limits altogether so that the rigmarole is unnecessary.