Is Your IRA an IOU to the IRS?

Careful planning for retirement has never been more important than it is today. IRAs and Roth IRAs can be important savings vehicles with significant tax advantages. A change to the tax rules for 2010 means that investors may want to reexamine their retirement strategy.

For those of you who have not already jumped onto the IRA bandwagon, a traditional IRA allows contributions of pre-tax money for those not covered by an employer's retirement plan or covered below a certain Adjusted Gross Income (AGI). Not only that, but contributions are allowed to grow on a tax-deferred basis until withdrawn in retirement, at which time tax is due on each withdrawal. Minimum distribution requirements apply starting at age 70 ½.

Contributions to a Roth IRA, on the other hand, are not deductible. Although contributions are taxable, investors get the same benefit of tax-free growth plus tax-free withdrawals for qualified distributions (if you've had the account for at least 5 years and you're at least 59 ½, or under certain other specific circumstances) and no minimum distribution requirements. Both traditional and Roth IRAs may penalize early withdrawals.

People often choose to convert a traditional IRA to a Roth if they determine it is in their best interests to pay taxes now instead of later.

Under current tax law, individuals can convert a traditional IRA to a Roth IRA if (1) they meet the $100,000 income eligibility test, and (2) they are willing to pay ordinary income tax on the amount of the conversion (previously deducted contribution amounts plus all earnings). The income limit effectively blocks upper income taxpayers from converting to a Roth.

In 2006, President Bush signed a $70 billion tax cut provision that eliminated the income limit for Roth conversions starting in 2010. Not everyone will be able to fund a Roth IRA (taxpayers earning over $110,000, or $160,000 for married joint filers, are still ineligible from funding a Roth IRA, and you are still required to have earned income in order to contribute), but everyone will be able to convert an existing IRA to a Roth IRA. In addition, those who convert in 2010 will be allowed to pay half the tax on the converted amount in 2011 and half in 2012, greatly decreasing the tax bite.

While this is a great opportunity for some, don't rush into it before you've considered all the factors of your personal financial situation.

1. How old are you? If you're in your 20s, 30s or 40s, you may want to consider this option further. If you're closer to retirement and know you'll have to start drawing on this money soon, this may not be right for you. Same if your life expectancy is short.

2. Do you have resources outside your IRA to pay the tax on the converted amount? Even with the government's "payment plan," this can be a significant amount.

3. Are you more interested in leaving an inheritance with your IRA than using it for your own retirement? Placing assets you won't need into a Roth IRA allows you the opportunity to build up a good inheritance with no required distributions, free of income tax. And although heirs will still pay estate tax on it, if they follow required withdrawal guidelines they will be able to leave the money in the Roth IRA to continue its tax-free compounding.

4. Do you expect to be in a higher tax bracket by the time you reach retirement? If you're in a high tax bracket now and expect it to be lower in retirement, a Roth IRA may not be the best option.

5. Is your traditional IRA still suffering the effects of the recession? If your account value is lower, you may end up paying taxes on a lower conversion amount right now if you convert from a traditional IRA to a Roth IRA.

There are numerous other nuances to consider so, as always, it's best to consult with your financial advisor before making a decision about a Roth conversion, as it may not be suitable for all investors.

Individual situations may vary. Investors should seek the advice of their financial advisor prior to making any changes to their investment or retirement strategy and seek the advice of their qualified tax advisor to discuss any specific tax related issues. Investors should note that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance of an index, investment or strategy cannot be relied upon as a guarantee of future results.

Securities offered through SagePoint Financial, Inc., member FINRA/SIPC. Investment advisory services offered through Asset One LLC, a registered investment advisor not affiliated with SagePoint Financial, Inc. Consistent Values, Inc., also a registered investment advisor is not affiliated with SagePoint Financial, Inc.

Pam Dumonceau, Owner, Consistent Values, Inc., a Registered Investment Advisor in Aurora, Colorado, may be reached at (303) 804-0101 or www.ConsistentValues.com, (303) 751-8859, 2851 S. Parker Road, Suite 900, Aurora, CO 80014.