Two Steps Ahead: Roth 2010–Big Opportunities?

With the lure of tax-free distributions, Roth IRAs have become popular retirement savings vehicles since their introduction in 1998. But if you're a high-income taxpayer, chances are you haven't been able to participate in the Roth revolution. Well, that's about to change.

Current rules

Currently, if your modified adjusted gross income (MAGI) is greater than a specific dollar amount, you can't make annual contributions to a Roth IRA:

Even worse, if your MAGI is greater than $100,000, you can't convert a traditional IRA to a Roth IRA. This $100,000 limit applies whether you're single or married filing jointly. And if you're married filing separately, you can't make a conversion at all--regardless of your income level.

What's changing?

On May 17, 2006, President Bush signed the Tax Increase Prevention and Reconciliation Act (TIPRA) into law. TIPRA repeals the $100,000 income limit for conversions, and allows conversions by taxpayers who are married filing separately, beginning in 2010. This means that regardless of your filing status or how much you earn, you'll be able to convert a traditional IRA to a Roth IRA starting in 2010. What's more, if you make a conversion in 2010, you can report half the income from the conversion in 2011 and the other half in 2012.

While the law doesn't repeal the income limits for annual Roth contributions, there's an easy workaround. Any taxpayer, regardless of income level, can make nondeductible contributions to a traditional IRA. Beginning in 2010, you can simply make your annual contribution initially to a traditional IRA, and then convert that IRA to a Roth.

Planning Now for 2010

Even though the new rules don't take effect until 2010, there are steps you can take now if you want to maximize the amount you'll be able to convert at that time.

For example, if you're not already making the maximum contribution to a traditional IRA, consider doing so. As noted above, you can make nondeductible contributions to a traditional IRA no matter how much you earn--up to $4,000 in 2006, $5,000 if you're age 50 or older. And your nondeductible contributions won't be subject to tax when you convert the IRA to a Roth in 2010--only the earnings will be taxed upon conversion. (The tax calculation is a bit more complicated if you've made both deductible and nondeductible IRA contributions.)

And don't forget that SEP and SIMPLE IRAs can also be converted to Roth IRAs. Consider maximizing your contributions to these plans now, and convert the IRAs to Roths in 2010.

Deciding whether a Roth conversion right for you and how the discipline of margin of investing fits into the picture

There are many factors to consider. One of the most important is trying to weigh the cost in taxes paid while saving the money and then placing it in a Roth. This estimate needs to be compared with the tax bracket one faces when withdrawing in retirement from a traditional IRA. The higher a person’s tax rate in retirement, the more attractive the Roth conversion.

There are other variables as well such as the period you have to invest tax-free (which can include health and life expectancy) and actual rates of return on investment. An unbiased assessment from a fee-only advisor may help in determining whether a Roth conversion is right for you. (Shameless plug: If you’d like to consult with Palmerston Group without obligation, please click here.)

Margin of safety investing and the Roth conversion

 Margin of safety or value investing attempts to identify temporary disparities in the market between the prices of securities (stocks and bonds) and their true intrinsic value. It’s a method of bargain hunting. When securities are excessively discounted by the market, the margin of safety investor buys them “on sale” and seeks to profit by waiting for the market to correct itself. There are very few truly great long-term investors, but many of those few follow some variation of a margin of safety.

This patience to outwait undue market pessimism may be especially valuable if the investment period of a Roth is sufficiently long-term. Because there are no taxes inside the Roth IRA or when money is withdrawn from it, the Roth IRA offers a remarkably attractive environment for conservative but opportunistic long-term investing. One outstanding practitioner, Southeastern Capital Management’s Longleaf funds, have set themselves a return on investment benchmark of 10% after inflation. While there’s no assurance that they’ll continue to achieve those kinds of results in the future, Southeastern and some other outstanding managers have shown it is possible. And $100,000 (after taxes) converted to a Roth and able to earn 10% (post-inflation) annualized returns for 15 years would be worth about $445,000 in today’s purchasing power. An investing horizon of 25 years would create a nest egg of about $1.2 million. If you are interested in learning more about this approach to wealth management, please feel free to explore Palmerston Group’s Margin of Safety University.

Adapted from material provided by Forefield Inc.