The Roth IRA Doors Open Wide: In 2010 even the wealthiest individuals will finally be allowed to establish this powerful retirement and estate-planning vehicle. But just because they can, does it mean they should?

Roth IRAs have never been popular vehicles for the wealthy. Their many limitations and restrictions have made them inaccessible for high-income earners. But next year the rules are changing. While the income (and other) restrictions on contributions to Roth IRAs will remain in place, the income restrictions on conversions of traditional IRAs to Roth IRAs will disappear entirely. For many affluent people this is welcome news.

What is a Roth IRA, and Why Should We Care?

 The now well-known individual retirement account was introduced nearly 40 years ago. Almost a quarter-century later, Sen. William Roth introduced a new type of IRA that came to be known (not surprisingly) as the Roth IRA.

The traditional IRA allows the owner to make tax-deductible contributions (in most cases) and accumulate wealth on a tax-deferred basis. With limited exceptions, periodic taxable distributions cannot begin (without penalties) before the age of 59½, but they must begin by the age of 70½.

The Roth IRA, on the other hand, allows the owner to make nondeductible contributions and then accumulate and distribute wealth tax-free, with no mandatory distributions during the participant’s lifetime.

 “Tax-free accumulation and distribution and no mandatory distributions during the participant’s lifetime are the three greatest benefits of the Roth IRA,” says Mitch Drossman, national director of wealth planning strategies for U.S. Trust. “Spouses who inherit Roth IRAs, for instance, can treat them as their own, meaning they can continue to grow their wealth on a tax-free basis with no required distributions.”

Both traditional and Roth IRAs have numerous complicated rules. Under the original law, applicable until the end of 2009, two limitations prevent taxpayers from converting. First, taxpayers with income in excess of $100,000 are not allowed to convert traditional IRAs to Roth IRAs. Second, a married person who files federal taxes separately cannot convert a traditional IRA to a Roth IRA.

The result?   Higher-income earners have been virtually shut out of Roth IRAs. But they won’t be for much longer.

The Rules Governing Roth IRAs Are Changing in a Big Way

A few years ago, Congress passed tax legislation that will allow traditional IRA owners, regardless of their income or filing status, to convert their traditional IRAs to Roth IRAs. The new rules take effect in 2010. “This is exciting news for many U.S. Trust clients and other affluent taxpayers,” says Drossman. “But it also entails certain up-front costs.”

The Roth IRA conversion requires owners to make an up-front payment of income tax. When taxpayers convert, they recognize ordinary income equal to the full value of the traditional IRA they are converting, reduced by any tax basis attributable to the converted IRA.

In addition, as part of the new legislation, if taxpayers convert in 2010, they can defer recognition of the income from the conversion equally over 2011 and 2012 or recognize all of the income in 2010.

“Spreading the conversion tax over two years would normally be a good move,” says Drossman. “But bear in mind that the taxpayer will have to pay the conversion tax a t the tax rates in effect in 2011 and 2012. If tax rates are expected to rise – and that’s exactly what we’re expecting – waiting may not make the most sense.

“But the bigger question is why anyone would want to pay income tax now. After all, conventional wisdom holds that it makes no sense to pay a tax up front for tax-free accumulation and distribution. When it comes to paying taxes, it’s almost always better to defer now and pay later,” he says.

“While that is often true,” adds Lester Law, a senior wealth strategist with U.S. Trust, “there are many potential benefits from conversion that can out-weigh the up-front income tax consequences. Individuals can use Roth IRAs in numerous ways j- during the owner’s lifetime to augment retirement savings, diversify retirement vehicles and make tax-free withdrawals whenever they’re needed. For those who do not anticipate the need to access their Roth IRA, the benefits may come in the form of increased wealth transferred to family members or other beneficiaries and a stream of tax-free distributions.”

“The bottom line is that a Roth IRA conversion is as much an estate-planning opportunity as it is an income tax-planning strategy,” adds Drossman.

 So Is a Roth IRA Right For You? Run the Numbers – Carefully

Roth IRAs could well be a compelling option, but they are definitely not for all tax-payers. Drossman explains that numerous variables need to be examined when considering whether to convert. These include the taxpayer’s current and estimated future marginal income tax rates, significant tax-favorable situations that may affect the federal and state income tax burden of conversion (for example, charitable contribution carryovers), any estimated federal and state estate-tax liability, current and future cash flow needs for lifestyle and estate-planning purposes, estate-planning goals, anticipated rates of return of assets inside and outside the IRA, the participant’s lfie expectancy, the beneficiaries’ life expectancy and the potential direction of income, gift, estate and generation-skipping transfer taxes.

Because so many variables need to be considered, it’s next to impossible for individuals working on their own to arrive at a quick, accurate and well-informed decision about whether conversion makes sense, Drossman observes. “ As is the case with most estate-planning decisions, the best approach is via detailed analysis – running the numbers – using sophisticated tools specially designed for that decision-making process,” he says.

Drossman does have caveats, however. “As with all tools that analyze data, it is critical that reasonable assumptions – life expectancy, IA values, tax rates and so forth – are used to generate meaningful information. Also, all tools are not created equally, particularly those that are available for free on the Internet. Many of these simplistic tools fail to take estate taxes into consideration, making complete and accurate results impossible.”

The bottom line is that there are no simple answers when it comes to Roth IRA conversion. Says Law: “At U.S. Trust, we believe the conversion decision needs to be made on a case-by-case basis with thorough analysis – by skilled professionals – of the client’s entire financial situation. We take a holistic approach of looking at your assets within, and out-side of, the Roth IRA, over your lifetime, as the participant, and your beneficiaries. Our planning specialists can walk you through the process and help you to arrive at the most appropriate solution. If you have a taxable state, a life expectancy of more than five years or a desire to leave the IA to non-charitable beneficiaries (your spouse and/or your children), I would definitely recommend that you contact your advisor to assist you in the analysis.”

“All caveats aside,” Drossman adds, “for those who determine that conversion makes sense, the Roth IRA can be an incredibly powerful retirement savings and wealth-transfer vehicle, and I do expect it to become increasingly popular in coming years.”

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