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Tax diversification made easier by new tax law

Our article entitled “Potentially Higher Tax Rates During Retirement Pose Risks” discusses the benefits of “tax diversi­fication” with your retirement sav­ings – owning both pre-tax and tax-free savings in an effort to hedge against the risk of tax changes in retirement.

The Roth IRA is a great way for many people to build up tax-free re­tirement savings. However, under previous tax laws, only taxpayers with income below certain levels were eligible to contribute to a Roth IRA, or to convert a traditional IRA to a Roth IRA.

The Tax Increase Prevention & Reconciliation Act (TIPRA), signed into law in May 2006, removes the income limit, thereby, enabling even high-income individuals to convert traditional IRAs to Roth IRAs. However, this does not take effect until 2010. Starting in 2010, taxpayers of any income level may elect to convert their IRAs. In add­ition, while previous tax laws did not allow married taxpayers filing sep­arately to convert, TIPRA removes that restriction.

A conversion of a traditional IRA to a Roth IRA is a taxable event – any previously deducted contributions, pretax rollovers, and earnings are sub­ject to federal income tax in the year of conversion. However, under TIPRA, taxpayers who convert in 2010 may choose to include the con­version income in 2010, or to recog­nize one-half of the income in 2011 and the other half in 2012. (For conversions made after 2010, income must be recognized in the year the conversion is made.)

High-income taxpayers should con­sider making non-deductible contribu­tions to traditional IRAs starting this year, in anticipation of converting those balances to Roth IRAs starting in 2010.

This tax law change is a potentially monumental event for many taxpayers, and — with prudent tax planning — could enable them to save significant amounts of income taxes during their retirement years.

Many factors should be carefully considered before you decide whether to take advantage of this new tax law. Mentor Capital can help you with this process as part of our comprehensive financial planning services.