[Updated Nov 2009] Following my recently updated article on new 401K and IRA limits, I thought I would look at some of the changes being made around traditional and Roth IRA's in the year ahead, including contribution and income limits. Roth IRA's generally differ from traditional IRA's in that contributions are made after tax, but this is offset by having to pay no taxes when the funds are withdrawn at retirement. Opening and contributing to a Roth IRA is currently restricted to those with an adjusted income limit (AGI) of $120,000 (individuals) and $176,000 (couples). Traditional IRA's don’t have income limits. The maximum annual contribution to Roth IRA's and traditional IRA's combined is $5,000 for savers under the age of 50 and $6,000 for savers over 50. The table below provides a summary of Roth IRA contribution/AGI limits from the IRS (click graphic to expand):

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When Can You Make Contributions? You can make contributions to a Roth IRA for a year at any time during the year or by the due date of your return for that year (not including extensions). You can make contributions for by the due date (not including extensions) for filing your tax return. This means that most people can make contributions for by April 15. For example, you can start or make 2009 Roth IRA contributions until in April 15th 2010.

You can also convert from a traditional to Roth IRA, but the rules are again quite restrictive. Only taxpayers with Modified Adjusted Gross Incomes (MAGI) of less than $100,000 in the year of conversion and not married filing separately may convert from a traditional IRA to a Roth IRA. However new tax laws in 2010 are changing the conversion limit, meaning that people who have or are interested in investing for retirement via IRA’s need to look at which vehicle and contribution method (post or pre tax) is best for their situation.

Next year, taxpayers making more than $100,000 a year in adjusted income will be allowed to convert to Roth IRA accounts from traditional IRAs. That means that more than 15 million Americans, can consider whether they want to make tax-deductible contributions if they have a traditional IRA or pay the taxes up front and have tax- free withdrawals during retirement with a Roth IRA. Which is better depends on future tax rates and how much the conversion will cost. It may not make sense to pay taxes today at a higher rate because many investors will be in a lower tax bracket during retirement, according to Tom Orecchio in a recent bloomberg interview of various tax and financial planners, a fee- only adviser at Modera Wealth Management. “From a tax perspective, I think when people do the math, it’s not going to be as game changing as they expect it to be,” Orecchio said.

For example, a taxpayer in the 28 percent federal tax bracket who shifts $100,000 of pretax dollars to a Roth IRA from a traditional IRA would pay $28,000 in taxes, in addition to whatever is owed in state taxes. “There are many people who simply don’t have that kind of a side account to pay the income tax, so for them it isn’t very practical to consider a Roth,” said Christine Fahlund, a senior financial planner at T. Rowe Price Group Inc. in Baltimore.

A partial conversion to a Roth IRA from a traditional IRA may be the most tax-efficient plan because of the diversification benefits, said Orecchio, who estimates about half of his clients may convert some money to a Roth IRA next year. “You never know how the tax code will work in the future. By owning different IRAs, you’re protected from whatever the government might decide to do,” Orecchio said.

Partial conversions may also be desirable for those with larger portfolios that would require a large tax payment at conversion, said Fahlund of T. Rowe Price. And the flexibility of partial conversions can also be beneficial to those who are self- employed or whose income varies year to year. In a year with less income, an investor can convert less of a traditional IRA to avoid having a larger tax burden for the year, according to Fahlund.



Holding Period

The Roth accounts, including those converted from traditional IRAs, must be held for five years and account holders must be at least 59 and a half before money can be withdrawn tax free. Savers who don’t follow the withdrawal rules or meet exemptions face a 10 percent penalty for distributions. Investors who decide to convert to Roth IRAs must declare the conversion amount on their tax forms. The tax owed depends on whether the assets being transferred are made up of pre or post-tax dollars. In 2010 only, converters will be able to pay the tax liability in 2011 and 2012.

There’s a fallback for investors who decide to convert and regret the decision. A Roth can be switched back to a traditional IRA account, or recharacterized. Since investors who convert to a Roth IRA don’t have to pay taxes on the conversion until the following year, they have until April 2011, or October 2011, if they get an extension to file, to reverse the conversion, said Slott, the IRA consultant.

Related:

~ Real Tax deductions that may surprise you
~ Single Step Personal Finance Challenge- Roth IRA
~ Why the fall in stock prices was good for your 401K
~ 401K Basics