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Big IRA change proposed - The Examiner

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05-04-2006

by Kathleen Pender, The  Examiner

A proposal in Congress would suspend the law that prevents people with more than $100,000 in income from converting a regular individual retirement account into a Roth IRA.

The change would take effect in 2010 and last for one or two years, according to Joel Friedman, a senior fellow with the Center on Budget and Policy Priorities.

It's part of a larger bill that would extend the tax cut on dividends and capitals gains for two more years. The Roth IRA provision supposedly would help pay for those cuts because conversions generate tax revenues in the early years. But it would reduce tax revenues in later years, just as Baby Boomers are retiring en masse.

"It's like taking out a mortgage to pay off a mortgage," says IRA expert Ed Slott.

Hugh Bromma, chief executive of Entrust Group, which provides services for self-directed IRAs, says, "We're pretty excited about this from our clients' point of view. From a national policy view, that's another story."

In a regular IRA, you get a tax deduction for dollars you put in and your earnings grow tax-free, but you pay ordinary income tax on every dollar you take out.

In a Roth IRA, you get no tax deduction for contributions, but your money grows tax free and there's no tax on withdrawals.

In short, a regular IRA gives you a tax break today, a Roth gives you one in the future.

Starting in 1998, Congress let people with $100,000 or less in modified adjusted gross income, convert a regular IRA into a Roth IRA. (The income limits for contributing to a Roth IRA are somewhat higher.)

The drawback to converting: You must pay tax on money you take out of your regular IRA. The upside: Once it's in your Roth IRA, you won't pay tax on that money or the money it earns.

In general, it's best to take your tax break when your income tax is the highest.

If you think your tax rate will drop in retirement, you're generally better off in a regular IRA. If you think your tax rate will go up, the Roth IRA is probably better.

Conversion limit the same

The $100,000 conversion limit is the same for married and single people and has never changed.

Starting this year, employers have been able to offer their workers Roth 401(k) accounts, which work like Roth IRAs but have no income limits and allow much larger annual contributions. Employers have been slow to adopt Roth 401(k) plans.

Many high-income people would jump at the chance to convert a regular IRA into a Roth IRA. Compared with lower-income people, they are more likely to be able to afford the up-front tax and less likely to see their tax rate drop in retirement.

Suspending the $100,000 limit "is a tax cut for high-income people. It's bad because it's being used to pay for another tax-cut for high-income people," Friedman says.

The cut in the dividend and capital gains tax is scheduled to expire after 2008.

Congress is negotiating a tax reconciliation bill that would extend those cuts through 2010. Even if those cuts expired after 2010, they would continue to reduce tax revenue beyond 2010. That's because some people who would have sold their investments after 2010 would sell them earlier, before the capital gains rate went up.

"If the tax reconciliation bill increased the deficit after 2010, it would violate a Senate rule that a reconciliation bill may not increase long-term deficits," Friedman says in a report. "The Roth IRA provision, in conjunction with other provisions, is supposed to address this problem."

The Joint Committee on Taxation estimated that suspending the income limit for two years would raise nearly $5 billion in the first four years, as high-income people converted their IRAs and made the required tax payments. But it would cost more than $9 billion over the subsequent six years.

(The committee assumed the income limit would be eliminated in 2006 and 2007, but Friedman says the effect would be similar if it was suspended in 2010 and 2011, which the proposal calls for.)

Friedman says the proposal is being debated by the Senate Finance Committee, but spokespeople for the Republicans and the Democrats on the committee refused to comment on it.

"We think the whole thing is terrible," Friedman says. "It's being used as a gimmick."