A Roth Deal and a College-Savings Dud
by Suze Orman
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Printable ViewEmail this PageMonday, June 5, 2006
You know how the supporting players sometimes steal the show from the stars? Well, I think that could be the case with the new $70 billion tax bill President George Bush signed in mid-May.


The extension of the low tax rate on long-term capital gains and dividends through 2010 got top billing in the early reviews of the new bill. While it's good news for investors that the rate will stay at 15 percent (10 percent for lower income individuals), I think the less-publicized nuggets in the tax bill are the real show stealers. One is potentially good news, and one is potentially bad news. Let's start with the good news.


Roth IRAs: Conversion Sweetener


I think the Roth IRA is one of the best investments, period. The money you put into a Roth garners no initial tax deduction, but your investment grows tax-deferred. And assuming you follow simple rules, you'll be able to withdraw all your money after you turn 59 1/2 without paying any income tax.


And hey, if you need some money before you're 59 1/2, your Roth can be a great emergency fund: You can withdraw any amount that you invest -- regardless of your age or how long the money has been in there -- without taxes or penalties. (It's the earnings on your contributions that need to stay put to avoid a penalty and tax for early withdrawals.)


Overall, the Roth is quite a deal. Remember, all the money you withdraw from a traditional IRA or 401(k) will be taxed at your ordinary income tax rate -- you don't even get to take advantage of the lower long-term capital-gains rates.


But plenty of investors have been shut out of Roths -- to be eligible to make a contribution, individuals must have modified adjusted gross income (MAGI) below $110,000 and married couples who file a joint tax return must have MAGI below $160,000.


The new tax bill creates a way for high-income individuals to get into a Roth. From 2010, anyone can convert money they've already invested in a traditional IRA -- including SEP IRAs -- into a Roth IRA. There'll be no income limit. That's a big change from the current law, which prohibits conversions if your MAGI exceeds $100,000. (An odd tax code quirk: That $100,000 applies to both individuals and married couples.)


Now, there's one hitch: When you convert to a Roth, you'll owe tax on whatever amount you've converted. That's because you never paid tax on any of that money, remember? But that's O.K. -- after paying the tax today, you'll never pay any tax in retirement.


And Congress is even giving you a nice bit of help with that tax bill -- if you convert in 2010, you'll actually get to spread your tax bill over two years: 2011 and 2012. That should ease your pain a bit.


Estate-Planning Benefit


O.K., so now you're interested but wondering if it makes sense for you to convert. The big factors to consider are: What's the length of time until you expect to start withdrawing the money, and what do you expect your tax rate to be when you're making those withdrawals. Generally, the younger you are, the more sense it makes to convert. Letting your money compound tax-free for decades is an investor's dream. The Roth also is a slam dunk if you're currently in a lower tax bracket than you expect to be at retirement.



It also makes sense to convert if you have a lot of money in an IRA and are looking for a smart estate-planning move. If you convert in 2010 and pay the income tax on it, that tax money is now out of your estate. And chances are your income tax rate today is lower than your estate tax rate down the line.


Another nice estate-planning attribute is that a Roth has no mandatory withdrawal rules. Unlike traditional IRAs, where you're required to start making withdrawals by age 70 1/2, you don't need to withdraw a penny from a Roth if you don't want to. You can leave it invested and pass it along to your heirs.


A Deal That May Not Stay Long?


There are so many creative ways for this bill to work to your advantage that I urge you to consider how it can benefit you. I personally can't wait to convert my SEP-IRA. Then my converted Roth will be the account that I use for aggressive growth. For the more I can get that account to grow after it's converted, the more money I will make tax-free. I can't remember when I've been so excited to take advantage of a tax law.


If the conversion makes sense for you, you might think about taking advantage of building up your IRA assets between now and 2010. For example, if you're self-employed, I would seriously think about stuffing as much money as you can afford into a SEP-IRA. You can invest up to 25 percent of earned income into a SEP, with a maximum limit of $42,000, in 2006.


Or just consider making a simple non-deductible IRA contribution each year until 2010. The maximum is $4,000 a year, or $5,000 if you're at least 50 years old. When you convert a non-deductible IRA into a Roth, you'll owe tax on the earnings.


This great deal may vanish before it even kicks into action. There's already some grumbling about how this provision is too short-sighted -- while it'll increase tax revenue in the first few years of the conversion expansion, the government also will forego collecting future tax on the money that would otherwise have been sitting in traditional (taxable) IRAs if there was no Roth conversion break.


Translation: The Roth break could disappear if Congress votes to undo it before 2010. If that happens, you still have a solid retirement investment, but you would lose the ability to have your money grow tax-free.


Rollover Recommendation


Moreover, I hear from so many people wondering what they should do with the money that's in an old employer's 401(k). With this new Roth conversion law, there has never been a better time to take the money out of your ex-employer's 401(k) and roll it over into your own IRA account at any brokerage or fund company. Once you leave a job, you're free to take your money out of the 401(k) plan and invest it on your own.


The smartest move is to do a direct rollover into an IRA -- you never touch the money, it goes directly from the 401(k) to the brokerage or fund company you choose. This allows you to sidestep some pesky tax problems. Once you get your 401(k) money rolled over, you can then convert it to a Roth IRA in 2010, and from that point forward your retirement assets are tax-free.


College Savings Hit


The other interesting "supporting player" in the new tax bill that could have a big impact is a change in how UGMA accounts are taxed. Before the rise of the 529 college savings plans, UGMAs were a popular vehicle for parents to build a college fund for their kids. But if you have an UGMA, your tax bill could become ugly.


With an UGMA, the first $850 in investment income this year is tax-free, and the next $850 is taxed at the child's tax rate. (Those rates adjust annually to keep pace with inflation.) Over $1,700, the parent's tax rate applies. Under the old law that parent's rate only applied until the child reached 14, at which point all the taxes were at the kid's rate. Assuming your child isn't raking in six figures raking the lawn, that was a nice tax break.


But under the new tax law, income above the $1,700 will be taxed at the parent's higher rate until the child reaches age 18. That's lousy timing if you're using the account for college: Right around age 14 to 15 is when it makes the most sense to start shifting assets from stocks into lower-risk bonds and cash, so the money will be there when the tuition bills start rolling in. But now you will have a higher tax bill eat into the college fund.


I've never been a huge fan of UGMAs -- beyond the tax complexity, your kid ends up with access to the money with not enough strings attached. So this latest change is the final nail in the coffin for me. If you're now considering your college savings options, skip UGMAs and take a look at 529 plans and Coverdell Educational Savings Accounts (ESAs). You can learn more about both at SavingforCollege.com.