Roth IRA could solve taxing problems

In 2010, anyone can make a Roth conversion — and have the option to divide the tax bill on the conversion over 2011 and 2012. To raise revenue, the U.S. government is allowing investors to convert existing IRAs into Roth IRAs. Even with paying current income taxes, this opportunity may still be a "win-win situation" for some investors.

Here's a big reason to go Roth in 2010: tax-free growth potential and distributions.

Roth IRAs provide the opportunity for:

» Tax-free growth and compounding of those IRA assets

» Tax-free withdrawals of the earnings of that IRA once the account owner is past age 59½ and has held the account over 5 years

» Tax-free distributions for heirs from the Roth IRA even over an extended time

Often, we think of the Roth IRA as a retirement planning vehicle — a vehicle to build wealth across one's lifetime. Actually, a Roth IRA has the potential to "stretch" and build wealth across generations.

With a Roth IRA, you don't have to take mandatory annual withdrawals. Those assets can remain in the account and compound tax-free. Instead of drawing down your IRA by the Required Minimum Distribution, or RMD, each year, with a Roth you can just let those assets compound and grow. Think about what an advantage that could prove to be financially.

Some people are wealthy enough that they don't need the bulk of their IRA assets. You might be one of them. You might want some or all of that money to go to your heirs, and it may frustrate you to have to take mandatory withdrawals from a traditional IRA. If you don't need all of the IRA assets, you can direct what you don't withdraw to your heirs. Your heirs won't have to pay income taxes on the withdrawals from the remaining IRA balance.

You are basically prepaying income taxes for your heirs when you make a Roth IRA conversion. The conversion doesn't trigger the gift tax, and your heirs won't owe income tax on withdrawals from the leftover IRA balance.

Further, you might contribute to a Roth IRA after age 70½ with no RMDs. If you have earned income, you can keep contributing to a Roth IRA after you reach the age of 70½. You can't do that with a traditional IRA.

If your traditional IRA is worth less now than it was, this might be an opportune time to convert that regular IRA to a Roth. Why?

» Today's federal tax rates may be lower than in the coming years

» You might find yourself in a higher tax bracket in future years

» Your IRA balance might increase in the next few years

While you could report half the taxable income resulting from the conversion on your 2011 return and the other half on your 2012 return — certainly a nice break from the federal government — you also have the option of paying it all on your 2010 return (which may actually be the better choice). If you file for an extension, you have until October 2011 to make that federal tax decision.

Keep in mind that the Roth IRA conversion itself is a taxable event. Additionally, the conversation may make your income appear higher if you have a student filling out a financial aid form for school. IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a Conversion from a Traditional IRA to a Roth IRA, or a Re-Characterization of a Roth IRA to a Traditional IRA. Before using such a strategy, consult your tax adviser.

Heidi Foster is a wealth adviser and investment manager with American Wealth Management and may be reached at www.financialhealth.com, 775.332.7000 or Heidi@financialhealth.com. Securities offered through LPL Financial member FINRA/SIPC.

These views are those of the author and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information.