by Bob Veres

All of a sudden, it seems like everybody in the financial planning world is talking about Roth IRAs and Roth conversions.  In fact, an article in Financial Planning magazine–one of the trade magazines in our world–recently proclaimed 2010 “The Year of the Roth.”

What’s the big deal?  Roth IRAs are interesting to professionals for several reasons.  With traditional IRAs (and qualified plans like 401(k)s), the money goes in untaxed, and you pay ordinary income taxes whenever you take money out of the account–which might be years in the future.  The Roth reverses this; your contribution is made with after-tax dollars, but then there’s no tax whenever the money is distributed.  If you believe, as many financial professionals do, that tax rates are going to go up in the future, then paying taxes now and eliminating future taxes provides a net gain.

It could get better.  Having money in a Roth account gives you a lot more control over your tax bracket in retirement.  For instance, you might take out just enough from your IRA distributions to fill the 15% bracket, and then take the rest of your living expenses out of your taxable accounts and Roth.  Another version of this kind of planning might help higher-income retirees avoid the brackets where Social Security income is taxed.

Another interesting thing about Roths is that, unlike traditional IRAs, they don’t have any minimum distribution requirements once you turn age 70 1/2.  So long as the money remains in the account, both Roths and traditional IRAs give you the benefits of tax deferral, which eliminates a significant drag on the growth of your money.  If you can afford to keep your money in the Roth account, and take retirement income from other sources, then the deferral can go on longer.

Alas, the Roth account will still be subject to estate taxes, and your heirs (not your spouse) will have to take required distributions each year once they inherit your Roth account.  But they won’t have to pay taxes on the distributions they receive–a nice additional gift for your children or grandchildren.

In the past, the only people who could set up a Roth IRA were those with less than $100,000 in taxable income, which eliminated a lot of the taxpayers who would benefit the most from all these features.  But now, as of January 1, anybody can open up a Roth IRA.  Most of the conversation in professional circles is about Roth conversions; that is, converting the money in your IRA to a Roth or taking a rollover distribution from a company retirement plan directly into a new Roth that you set up.

Should you do this?  Unfortunately, that’s a complicated question, since any money moving from a traditional retirement account to a Roth requires you to pay taxes on the money in the traditional account.  Some of that can be deferred; with any conversion that takes place in 2010, the tax obligation can be split between the 2011 and 2012 tax returns, which represents a (very) short-term loan from the IRS.  So professional advisors are looking at individual situations, looking for portfolio losses that can be used to offset the tax burden, projecting tax brackets over the next three years and a host of other issues, including how long each person will have the money in the Roth account, and where the money to pay the taxes will come from.  (If you have to pay the taxes out of the IRA, then you lose the value of future deferral–not good.)

Another issue is: Do we trust Congress to keep its promise not to tax Roth distributions in the future?  Few of us ever expected to pay taxes on Social Security payments.

Fortunately, the law allows for partial Roth conversions–moving some of the money over, rather than all of it–and also lets you reverse the conversion (professionals call it a recharacterization) any time before October 15 of the year after the conversion.  All of this means that the conversion decision, and the amount to convert, will probably be different for you than it is for the person next door, whose decision will be different from the family down the street.

Meanwhile, you have to wonder how alert are the people who write our tax laws.  Under the current rules, single persons earning more than $105,000, and joint filers over $167,000, are sternly prohibited from making a full contribution to their Roth account.  If you earn more than $120,000 (single) or $177,000 (joint), you’re forbidden to make them at all.

But…  People in these income brackets are perfectly free to make a traditional IRA contribution–and the law says they can immediately turn around and convert the money into a Roth account.  Does that make sense to you?

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