morgan column

Dale Ishida Suezaki | financial adviser

Shut out from Roth IRAs no longer

Thanks to some recent tax law changes, high-net-worth individuals who are exploring additional ways to build retirement savings may want to take a closer look at traditional IRAs. In May 2006, the Tax Increase Prevention and Reconciliation Act revised some of the guidelines covering IRAs. As a result, high-income investors whose earnings level would previously have restricted them to a traditional IRA can now convert those to Roth IRAs starting in 2010 and reap the long-term tax advantages.

Because they allow qualified investors to withdraw all contributions and those earnings that meet certain requirements without federal income tax, Roth savings vehicles now appeal to a growing list of investors. Previously, Congress limited Roth conversions to those whose modified adjusted gross income was under $100,000. Under the new rules, however, the conversions will be available to investors at any income level, starting in 2010.

So if you’ve maxed out your 401(k) contributions and don’t qualify to make Roth IRA contributions because of your income level, you still can make nondeductible contributions to a traditional IRA over the next several years and then convert it to a Roth IRA in 2010.

Then, when needed during retirement, investors can make withdrawals from the Roth IRA tax-free. Taxes will not be owed on the original nondeductible contributions because they’ve already been paid, although the previous earnings on those contributions will be taxable. Those who convert in 2010 only have the extra incentive of being able to spread the tax liability over the following two years. Thereafter, all future earnings in the Roth IRA will be available for tax-free distributions if certain requirements are met.

With a traditional IRA, account holders are taxed on both their original contributions and their investment earnings when they start withdrawing money. Essentially, the tax responsibility has been deferred, not eliminated. The tax responsibility for a Roth IRA comes at the front end with nondeductible contributions. One of the advantages to account holders, however, is that they do not have to pay any taxes — even on investment earnings — at the time of withdrawal. And that means that Roth IRAs essentially can make investment income tax-free income.

The opportunity to translate nondeductible contributions into additional savings that could result in a tax-free income stream for retirement is especially attractive for high-net-worth individuals who can afford to pay the conversion taxes without using funds from the account itself. By doing so, an investor can avoid paying taxes on the distribution, as well as an early distribution penalty of 10 percent. This assumes that a Roth IRA has been open for at least five years and the investor is at least age 59 1/2. Moreover, because high-net-worth families often have retirement income from other sources, they may not need to tap into their converted Roth IRA for many years, if at all. (Unlike traditional IRAs, there are no mandatory withdrawal rules for Roth IRAs if individuals are 59 1/2 and the Roths have been established for five or more years.) So investors who choose the conversion option can theoretically shelter their earnings for years — an attractive advantage in estate planning.

If you already have a traditional IRA with pre-tax dollars (i.e., deductible contributions, rollovers from qualified plans), you should consult your tax adviser about the aggregation rules that will apply if you convert any traditional IRA assets to a Roth IRA. Tax laws are complex and subject to change. This information is based upon current federal tax rules in effect at the time this was written. Morgan Stanley and its financial advisers do not provide tax or legal advice, and are not “fiduciaries” under ERISA with respect to the services or activities described herein. Articles are published for general information purposes and are not an offer or solicitation to sell or buy any securities or commodities.

Dale Ishida Suezaki is a financial adviser with Morgan Stanley, 329-7979.