Tax-Free Income!

IRAs (Individual Retirement Accounts) come in two flavors—traditional and Roth. Many taxpayers would prefer the Roth variety, but they’ve been prevented by law from contributing to one. Restrictions will loosen up in January, when most people with earned income (and their spouses), as well as many retirees, will be allowed to convert traditional IRAs to Roth IRAs.

Why are Roth IRAs so attractive? Tax-free income. Once you have had a Roth IRA for five years, all distributions from it are tx-free as long as you are at least 59 1/2 years old. In contrast, most distributions from traditional IRAs are taxable and vulnerable to any increase in tax rates. Freedom from required minimum distributions (RMDs). No matter how old you are, you won’t have to withdraw anything from your Roth IRA if you don’t need the money. No income cap. Through 2009, you can’t convert a traditional IRA to a Roth IRA if your modified adjusted gross ­income (MAGI) is more than $100,000. That ceiling applies to single and joint tax returns. As of 2010, the income cap will be eliminated. Going forward, anyone can convert a traditional IRA to a Roth IRA, regardless of income.

When you convert a traditional IRA to a Roth, you will owe tax on the “pretax” dollars—money that has never been subject to income tax. Example: A woman has $100,000 in her traditional IRA. All that money came from tax-deductible contributions and subsequent investment earnings. If she converts the account to a Roth IRA, she will have to report $100,000 of taxable income in the year of the conversion. Loophole: For Roth IRA conversions made in 2010 only, the resulting taxable income can be divided equally between 2011 and 2012. Thus, you can delay paying the tax—or you can choose to report the full amount in 2010, when tax rates may be lower than rates for 2011 and 2012.

Who is a good candidate to convert a traditional IRA to a Roth IRA? Someone in a low tax bracket. Someone who wants IRA beneficiaries to inherit a valuable asset. After your beneficiaries inherit, they can take substantial tax-free distributions. Someone worried about steep future tax rates. Federal income tax rates are relatively low now, but they might go higher as the government copes with Medicare, Social Security, stimulus promises, etc.

Who shouldn’t convert a traditional IRA to a Roth IRA? Someone about to retire and tap his/her IRA. If you’re working now and earn a significant income, you might owe 28% or 33% tax on a Roth IRA conversion. It doesn’t make sense to pay that much tax if you’ll soon retire and fall into the 15% tax bracket. Someone planning to move to a low-tax state. Why convert now and pay tax to a high-tax state when you will be relocating to, say, Nevada or Florida, where there’s no state income tax? If you decide to convert…Pay the conversion tax with money outside your IRA. If you pay the tax with IRA funds, you will reduce the account’s value and might owe a 10% penalty on IRA withdrawals before age 59 1/2. “Fill up” a low tax bracket. Suppose that the 15% tax bracket goes up to $70,000 of taxable income in 2010 on a joint return. A couple projects their taxable income at $50,000. They can move $20,000 from their traditional IRAs to Roth IRAs and still owe only 15% in federal income tax on the converted amount.