From a tax perspective, saving for retirement used to be a heck of a lot simpler.  You'd deduct the money contributed into your employer sponsored retirement plan or IRA, and then would pay taxes on money withdrawn from those accounts down the road. 

Everything changed back in 1998 with the introduction of Roth IRAs. You now have the option of foregoing a tax break today in exchange for tax-free growth within your Roth account.  As long as certain conditions are met, you'll owe no taxes on money withdrawn from your Roth IRA. 

The government even went one step further.  The 1997 Tax Act provided a provision allowing people to convert their existing IRAs to a Roth IRA.  Yes, they would owe taxes on the amount converted, but the IRA account would then grow tax-free from that point forward.  The only catch is that you can only convert your IRAs in a year that your income does not exceed $100,000. Please note that the same $100,000 threshold applies to single individuals as well as to married couples, and has not increased for inflation since being implemented back in 1998. 

During 2006, there have been two major changes to tax-free Roth accounts.  One change was introduced in 2006 as part of the recent Tax Act, while the second change, enacted as part of the 2001 Tax Act, finally took effect on January 1st.

Income Limitation For Roth Conversions Disappears in 2010

The Tax Increase Prevention and Reconciliation Act, signed into law on May 17, 2006, eliminates the income limitation for people looking to convert their IRAs to a Roth IRA, effective in 2010.  If you convert your IRAs in 2010, the new rules give you the option of paying all the taxes in one year, or spreading the tax bill over the following two years.

So what should you do?  Start by taking advantage of the opportunity to build up your IRA accounts over the next five years.  With a maximum IRA contribution of $4,000 per year through 2007, increasing to $5,000 for the three subsequent years, you can add $23,000 into your IRA between 2006 and 2010, increasing the money available to be converted.

Are you 50 or older?  If so, you can make catch-up contributions of an extra $1,000 per year, adding an additional $5,000 into your IRA accounts by 2010.

Even if you're covered under a retirement plan at work, you have the option of contributing to your IRA account each year.  The amount you contribute might not be tax deductible, but that's okay, since you won't be taxed again on those non-deductible contributions when you convert your IRAs to a Roth IRA.

If you're married, your spouse can also contribute to an IRA each year.  The only requirement is that your combined earned income, including wages and net self-employment income, exceed the total amount contributed into your IRAs.

Roth Planning Opportunity For High Income Taxpayers

Through 2010, there is an opportunity available to high-income taxpayers looking to take advantage of these new Roth conversion rules.  Let's look at the basics:

• Starting in 2010, anyone can convert their IRAs to a Roth IRA since the $100,000 income limitation has been eliminated.
• If you work and are covered under an employer sponsored retirement plan, or are self-employed and contribute to your own SEP, SIMPLE or other retirement plan, your IRA contributions aren't tax deductible if your 2006 Adjusted Gross Income (AGI) exceeds $60,000 if single or $85,000 if married.
• If you work and are covered under a retirement plan during the year, and your spouse either doesn't work or works but isn't covered under a retirement plan during the year, your spouse's IRA contributions aren't tax deductible if your combined AGI exceeds $160,000.
• You're not eligible to contribute to a Roth IRA in any year that your AGI exceeds $110,000 if single or $160,000 if married.

Here's the plan.  For this example, let's assume your income each year exceeds the applicable thresholds so you're not eligible to make tax-deductible contributions into your traditional IRA or to contribute to a Roth IRA.

Starting in 2006, contribute the maximum to your IRA each year.  Then, in 2010, convert your IRA to a Roth IRA.  Assuming you have no other IRA accounts, you'll only be taxed on the portion of the 2010 value of this account that exceeds the $23,000 you invested between 2006 and 2010, since those IRA contributions weren't previously tax deductible.

Even though your income was too high to contribute to a Roth IRA over the years, by making non-deductible IRA contributions between 2006 and 2010, and then converting your IRA in 2010, you basically ended up contributing to your Roth IRA each of those years. 

The New Roth 401(k) or 403(b)

The second big change, introduced as part of the 2001 Tax Act, finally went into effect this year.  As of January 1, 2006, employers can amend their retirement plans to allow their staff to designate their salary deferrals as Roth contributions.

While contributions made into your current 401(k) or 403(b) plan reduce your taxable earnings, you'll be taxed on money withdrawn from these retirement savings accounts down the road.  With a Roth account, you forego a tax savings today, but the money invested within the account grows tax-free - provided you're at least 59 1/2 and the account has been open for at least five years before any money is withdrawn. 

If your employer provides you with the opportunity to contribute to a Roth 401k or 403b account, what should you do?  If you trust the government not to substantially change the Roth rules between now and when you retire, consider going with the Roth if:

• You're relatively young and plan to keep the money invested for a long time.
• You're in a low tax bracket today, or feel that tax rates will be higher in the future.
• You've always wanted to contribute to a Roth IRA, but your income has consistently been too high for you to put money into one.
• You want your heirs to keep as much of the money they inherit from you as possible, since they won't owe income taxes on distributions received from Roth accounts.  (However, the amount they inherit from you might be less since you've paid higher taxes in years you contributed to a Roth 401k.)
• You don't rely on the tax savings realized on your current contributions to your 401k or 403b account to meet your household budget.

For 2006, you can elect to contribute a total of $15,000 into a 401k or 403b account through salary deferrals.  Anyone 50 or older by the end of the year can contribute an extra $5,000.  If your employer offers a Roth, you'll allocate your salary deferrals between your Roth and non-Roth accounts.  Even so, any matching contributions made by your employer go into a non-Roth account.

Amounts contributed to a Roth account at work don't limit the amount you can contribute into your own Roth IRA.  For 2006, you and your spouse can each contribute up to $4,000 ($5,000 if 50 or older) into a Roth IRA.  Eligibility phases out for single individuals earning between $95,000 and $110,000 and for married couples earning between $150,000 and $160,000.

Here are a few other rules about Roth 401k's.  Contributions made into a Roth account must be segregated from your non-Roth money.  Elections to contribute to a Roth are irrevocable, and money can't be transferred between Roth and non-Roth accounts.  If you change jobs, you'll roll the money from your Roth account into your new employer's Roth 401k, or into a Roth IRA.

Major Changes = Tough Decisions

Thanks to these major changes to Roth accounts, most taxpayers are now faced with two tough decisions.  While the tax-free growth provided by Roth accounts is very attractive, taking advantage of these two new rules will cost you additional taxes in the short run.  By converting your IRAs to a Roth IRA, you'll owe income taxes on the amount converted.  And by going with a Roth 401(k) or 403(b) at work, you forego a current year tax break.

Are these prudent steps to take?  You'll only know for sure when it's time for you to withdraw money from these accounts and can see whether tax rates have risen over the years, and whether Roth distributions have remained completely tax-free as promised back in 1997.