When the calendar passed from December to January, we bid a not so fond adieu to 2009 as well as the rollover income limitation associated with transitioning a traditional IRA to a Roth IRA. This is a good thing if  converting to a Roth IRA makes sense for you.

The Roth IRA is one of the best retirement and estate planning tools available, and with the recent change in restrictions and tax payment scheduling, 2010 is the year of the Roth. Quite simply, if the Roth makes sense for you then 2010 is likely the year to make it happen.

Here are 8 ways not to screw it up.

1. Just Do it.

As many experts look at the mounting federal deficits and growing number of states in danger of bankrupting themselves, they see no choice but for taxes to skyrocket. Maybe, and maybe not. I’m not going to get on a political riff on the subject of reckless spending and taxes. I just want you to be aware that the chances are slim that tax rates will stay at their current rates, which are historically low.

So, the question for long term investors is not whether to fund a Roth, but how to fund a Roth IRA. Regarding a rollover from a traditional IRA, your choices are essentially:

1. Convert your IRA all at once.
2. Convert your IRA in stages, or segments.

Either way, if you don’t at least start to convert now, and you wait to do it later it may cost you dearly in terms of taxes. If you’ve decided that a Roth isn’t for you, then… why are you reading this article? Besides, since January 2010, all income limitations have been removed.

2. Understand the tax consequences.

Deciding to wait and do a conversion after taxes rise is a costly mistake, but so is jumping into a conversion without understanding the full tax implications.

For example, if you’re in a 15% income tax bracket today and you rollover a $250,000 IRA you will not pay 15% in taxes. You will end up paying quite a bit more because that $250,000 distribution can be counted as income, according to Barry Picker (who recently served as the technical editor of “100+ Roth IRA Examples and Flowcharts,” by Robert Keebler) and that will most likely bump you into a higher income tax bracket.

3. Know the direction of your tax bracket.

If you are the sole breadwinner today, but your spouse is likely to re-enter the workforce in a year or two, then you’re better off converted at today’s lower tax rate. On the other hand, if your spouse is considering staying at home with the baby that’s due in a few months, you’re better off waiting until she leaves the workforce and your combined income drops. Likewise if you file solo, but you’re thinking of tacking a pay cut to switch careers. Time your conversion when your tax rate is likely to be on the low side.

4. Don’t pay taxes with money from your transaction.

Paying the taxes with money you have withheld from the rollover transaction is a bad idea for a number of reasons, including:

Every penny you take out of the transaction is less that goes to work for you in the Roth.

The amount withheld goes to the IRS as an advance payment, and also reduces the total conversion amount. Hence, the amount withheld is considered a distribution and not part of the conversion and can impart further tax liabilities. For example, if you have a $100,000 IRA that you convert to a Roth IRA and withhold $20,000 (20%) for taxes, then the $20,000 is treated as a distribution and may be taxable in itself.

If you need to reverse the conversion (called a re-characterization – more on that below), then you can only reverse the amount actually converted. In the example above, you could reverse the $80,000 conversion, but you’d be out that $20,000 permanently – and you would still owe taxes on the $20,000.

The amount withheld for taxes is also subject to the 10% early distribution penalty, unless you are 59 1/2 when the conversion occurred.

5. Be a good judge of re-characterization.

If not converting is a mistake, not paying attention to your Roth after you’ve converted is a huge mistake. Here’s why – and incidentally, here’s one of the greatest aspects of the Roth IRA conversion. It’s called “re-characterization” and here’s how it works.

Re-characterization allows you to undo a conversion if the market value falls below your conversion amount. It’s the mulligan of the Roth world. Here’s an example:

You have $100,000 in your traditional IRA when you convert it to a Roth IRA. After a while, the your Roth is worth only $50,000. If you left your Roth alone, you’d owe taxes on the full amount at the time of conversion – $100,000. But, if you re-characterize your Roth (i.e. undo the conversion, you get your $100,000 back in a traditional IRA and you would owe taxes on the $50,000 re-characterization amount.

Of course, you have to do it before the next tax filing deadline after your initial conversion and if there are fees involved, you might want to makes sure you’ve lost enough value to make it worth your trouble.

6. Divide and conquer.

Besides the income limitations being dropped, you also get an extension on when you have to pay the taxes if you convert in 2010. For this one year only, you can spread your payment of the taxes you owe on the amount converted over the 2011 and 2012 tax periods; meaning you don’t have to actually pay them until 2012 and 2013!

7. Catch the early bird special.

If you convert early in 2010 and the market resumes its bull run, as some analysts think may happen, then you would have more time to catch those tax-free gains, while splitting the payment of the taxes owed over two year’s.

8. Hedge your bets.

You can split your conversions up into multiple conversions, by asset class for example. That way if your stocks perform well, but your bonds tank, you can re-characterize your bond conversion back into a traditional IRA and lessen the tax hit. In fact, many experts recommend slicing your IRA up into as many Roth IRA accounts as possible to gain maximum control over your taxes. This is probably only beneficial for very large accounts however.

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This is a friendly reminder for anyone with retirement savings who is concerned about paying higher taxes in retirement: new tax rules remove earnings limits on Roth IRAs.

Prior to the start of 2010, you could not open a Roth IRA if:

• Your individual adjusted gross income was $120,000 or more
• You and your spouse’s adjusted gross income was $176,000 or more
• You are a married taxpayer who filed separate returns from your spouse

But all of that changed on January 1, 2010. Those limitations have been permanently removed.

This opens the doors to millions of IRA and 401(k) account holders to convert those accounts to a Roth.

Reasons to convert.

Taxes.

Unlike IRA and 401(k) contributions (which are pre-tax), Roth IRA contributions are after tax. But withdrawals from Roth IRAs are tax-free, where IRA and 401(k) withdrawals are taxed at your income tax rate.

Required distributions.

There are none!

You can keep your savings in a Roth IRA as long as you want – and even leave them to your heirs upon your death.

Benefits for heirs.

If you leave your Roth IRA to your children, they don’t pay taxes on that money either!

You may be on the fence about whether to fund a Roth or traditional IRA, but here are two things to consider.

• First, if you’ve been smart with your money, and invested well you will likely be withdrawing more money than you think you will in retirement. This is especially true if your savings are in an IRA or 401(k) or similar plan that requires mandatory distributions after a certain age.

• Secondly, taxes will most certainly be higher in the future than they are today. Even before the current crop of politicians in D.C. quadrupled the deficit, tax cuts were set to expire and rates to return to higher levels. The recent spate of uncontrolled spending in Washington only sets the stage for even higher taxes down the road.

Source

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It seems counter intuitive, that choosing the wrong kind of savings account for your child’s college fund could actually cost your child more, but that’s the world we live in – make the wrong choice, and your child may lose thousands of dollars in financial aid come enrollment time.

According to Robert Helgeson, director of financial aid for Valparaiso University in Indiana:

“If a parent has $100,000 in assets, the government is going to expect them to contribute $6,000 of it to education. If a student has $100,000 in assets, the government will expect $20,000.”

So, you can see where you stash your money is just as important as how much you stash.

According to the U.S. Department of Education, the student can have up to $3,000 saved in a checking or savings account in their name without losing any financial aid, but every dollar above that takes 20 cents away from any federally funded scholarships and grants junior would have been eligible for. After that, the money would be subtracted from federally funded loans.

Here are 3 places to safely shield your college savings without causing the loss of any aid.

529 college plans

This is perhaps the most popular method among younger parents. 529 plans are much like 401(k) or IRA plans, except you’re saving money for college instead of retirement. But the idea is the same. You contribute money to the plan, set your desired allocations for the money (choose between stock, bond and money market funds), and the money grows tax free – provided it is only used for education related expenses. An added perk to many plans is that if you live in the state that offers the plan, you can often deduct your contributions from your state income tax bill. 529 plans offer flexibility in determining the “owner” of the plan as well, since the parent can control who the beneficiary is. This means that if junior decides he’s going to the #1 party school, and he doesn’t really know what for, you can keep the funds from him until he gets his act straight.

529 plans do carry some restriction though. For example, the funds can only be withdrawn tax-free for educational expenses. Also, the funds available for allocation are limited.

UGMA and UTMA Custodial Accounts for Minors

The Uniform Transfers to Minors Act (or Uniform Gifts to Minors Act) provide a alternative methods of transferring ownership of cash and other financial assets to children who are too young to handle such assets, that may be simpler, cheaper and faster than a trust. Before the 529 plan became ubiquitous, the UGMA and UTMA accounts were often used as a means for parents and grandparents to provide savings for children and grandchildren.

According to the IRS, the first $950 in gains is tax-free, the second $950 is taxed at the child’s income tax rate and the remainder is taxed at the parent’s income tax rate. As you can see, the tax benefits are not nearly as robust as they are in a 529 plan, but the UGMA and UTMA custodial accounts place no restrictions on what the money can be used for. This can be good or bad, depending on your situation. For example, the child becomes the sole beneficiary of the assets in the account at age 18 or 21 (depending on the state you live in), so there’s no way to make sure junior spends that money on college and not a trip across Europe.

Roth IRA

The Roth IRA is an Individual Retirement Account in which you pay taxes on the contributions, but not on the withdrawals – ever. So what’s in doing in a list of college savings accounts? I’m glad you asked.

Once the child has an earned income, he can open a Roth IRA. Once the child turns 18, he has sole control of the account, so here again the parents lose control over what the money is spent on. One important restriction on the Roth is that withdrawals can only be made on the earnings after the child turns 59½. BUT, contributions can be withdrawn tax free at any time. So, if you’re looking at stashing a large sum of money for college, a Roth is a great way to shield the money from financial aid formulas and give the child a head start on retirement savings, since any money earned after the contributions will continue to grow tax free since it can’t be withdrawn until the child turns 59½.

Conclusion.

It seems that the custodial account is really a dinosaur when it comes to savings vehicles for children, but the 529 and Roth can be incredibly beneficial. If you’re a young family, with only a modest amount of money available to contribute on a steady basis, the 529 plan is probably the best choice. But if you come into an inheritance, or the grandparents want to make a one-time gift and you don’t mind the possibility of your child being able to use the money for something other than college, a Roth IRA is definitely worth a look.

Photo © by alancleaver_2000

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