Tax Increase Prevention & Reconciliation Act of 2005 and 401k Retirement Plans

The Tax Increase Prevention & Reconciliation Act (TIPRA) of 2005 was signed into law by President Bush on May 17, 2006. TIPRA includes a provision that facilitates the conversion of Traditional IRAs to Roth IRAs. If you read the article on Roth IRA Rules, you will know that if your Modified Adjusted Gross Income (MAGI) exceeds $100,000, you are NOT eligible for a Roth IRA conversion. Why would you want to do a Roth IRA conversion? Tax-deferred growth of earnings, tax-free distributions and no minimum required distributions (RMD) are some of the reasons.

From January 1, 2010, the above rule of $100,000 maximum income limit for Roth IRA Conversions will be scrapped. Also, investors who do Roth IRA conversions in 2010 will be able to spread their tax obligations over 2 years, 2011 and 2012. This interest free loan from the Internal Revenue Service (IRS) has to be repaid over a 2 year period.

What can you do in order to maximize the opportunities created from this Tax Increase Prevention & Reconciliation Act of 2005 law? Take a look:

1) Maximize Your Non Roth IRA Contributions

You should contribute as much as you can towards other retirement plans such as the SEP IRA, SIMPLE IRA, 403b plan or 401k plan. Once you have accumulated a huge nest egg in any of these retirement plans, you can then convert them to Roth IRA in 2010.

2) Choose Non Deductible IRA as the next Option

If your modified adjusted gross income (MAGI) exceeds $100,000, you are not eligible to contribute towards a Roth IRA. However, your next best option may be a nondeductible IRA. Provided you have employment income, are under the age of 70 and 1/2, you can contribute $4000 a year ($5000 a year if you are 50 years or older). Yourself and your spouse combined can contribute $8000 a year ($10,000 if both you and your spouse are 50 years or older).

Compounding Interest & Contributing Towards a Non Deductible IRA

Consider this hypothetical example where you invest $10,000 into your non deductible IRA (both you and your spouse are 50 years old at this time). The average annual return you achieve is 6% compounded annually. At the time you turn 65, here’s your nest egg:

Current Principal $0
Annual Addition $10,000
Years to Grow: 15
Interest Rate 6%
Compounding Interest: Annual
Nest Egg at 65 Years $246,725.28

Here’s the analysis. You contributed $10,000 a year for 15 years. This means your total contributions are $150,000. However at the age of 65, you would have a whopping $246,725.28!

$10,000 per year for 15 years $150,000
Nest Egg at 65: $246,725.28
Nest Egg – Contributions ($246,725.28 – $150,000) $96,725.28

At this point, you will have to pay taxes only on the earnings of $96,725.28 (after converting to a Roth IRA) in 2010. Also, you will not have to worry about the minimum required 401k distributions.

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