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Roth IRAs

Family-Friendly Relief

New rules for Roth IRAs and capital gains will benefit parents and kids.

For once, you don't have to rush. Congress's latest effort to tweak the tax code includes two significant opportunities for future tax savings -- and gives you plenty of time to plot your strategy.

One change allows anyone to convert a traditional IRA to a Roth IRA. The other change eliminates capital-gains taxes for taxpayers in the lowest two tax brackets for three years. Both provisions will help upper-income families cut their tax bills by gifting assets to their kids or leaving a Roth IRA to their heirs.

Currently, only taxpayers with incomes of $100,000 or less are eligible to convert traditional IRAs to Roth IRAs. You must pay income taxes on the entire amount that you convert to a Roth IRA. But all withdrawals in retirement, including earnings, are tax-free as long as you are at least age 591Ú2 and wait at least five years after making the conversion.

The new law eliminates the income ceiling for Roth conversions. If you convert to a Roth IRA in 2010, the first year this option will be available, you won't have to pay taxes on the conversion until the following year. Even then, you'll be able to spread your tax bill over 2011 and 2012.

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To get the full benefit from future tax savings, pay the taxes from assets outside your IRA. The delayed start gives you time to come up with the cash.

The new law also has significant estate-planning implications because Roth IRAs have no mandatory distribution requirements and withdrawals by heirs are tax-free. (Withdrawals from traditional IRAs are taxed in the heirs' top tax bracket.) "A Roth IRA is one of the most valuable assets a couple can leave their children and grandchildren," says Christine Fahlund, T. Rowe Price's senior financial planner. "The investments are tax-sheltered, the income can be tax-free, and after the death of the IRA account owner, those who inherit the assets can make withdrawals based on their own life expectancies."

Parents looking to avoid capital-gains taxes can transfer assets to children in the 10% and 15% tax brackets, who qualify for tax-free capital gains beginning in 2008. The tax-free period for those in the lowest two tax brackets will last through 2010.

But there's a catch. The new law also bumps up the age for the "kiddie" tax. Under current law, most investment income earned by children under age 14 is taxed at their parents' higher rate. The new law will apply the kiddie tax to investment earnings by kids under age 18. So if you transfer assets to a child, he would have to wait until his 18th birthday to take advantage of a tax-free sale.