Roth IRAs for Everyone

For a number of years I’ve advised clients against nondeductible IRAs. As a quick review, nondeductible IRAs are for folks with incomes too high to be eligible for regular deductible IRAs or Roth IRAs. Nondeductible IRAs offer no upfront tax deduction, but the earnings and growth of the IRA are taxable when withdrawn. And, that’s why I haven’t liked them. Assuming you’re not doing a lot of trading in your IRA, most of the IRA’s growth will be in appreciation. Outside of an IRA that appreciation gets taxed at low capital gain rates. However, if distributed from an IRA the appreciation gets whacked with the higher ordinary income tax rates. I just haven’t believed the tax deferral of the IRA overcomes the higher tax rates upon withdrawal.

Congress has recently (Tax Increase Prevention and Reconciliation Act of 2005, passed in May 2006) changed my mind. Beginning in 2010 anyone, no matter the income level, can convert a regular IRA or nondeductible IRA to a Roth IRA. The hitch? You have to pay the tax either at the time of conversion or 50% in each of the years 2011 and 2012. So, why do I think this is a good idea? I figure just about everyone under age 60 (and some those over age 60 also) should have a Roth IRA. The problem is that most of my clients have been locked out of Roth IRAs due to the income limit. Now they can have a Roth IRA by funding a nondeductible IRA for 2006-2009 and then converting to a Roth in 2010. The tax shouldn’t be too oppressive since only the earnings and growth will be taxable. And, there’s the special two-year tax spread.

I’ve never had an IRA (for the above reasons). Count me in for 2006.