New rules ease transition to Roth IRAs

Beginning in 2005, a little-known change in the tax law will allow more people, primarily older and wealthier retirees, to move funds from their traditional IRA to a Roth IRA.

For many, a Roth IRA is preferable to a traditional IRA primarily because of the tax-free earnings on distributions if the Roth IRA is established for at least five years and the distributions are taken after age 59 1/2. It’s also beneficial if you think you’ll be in a higher income tax bracket in future years. Additionally, if you have earned income, Roth IRA contributions can be made indefinitely, regardless of age. And Roth IRAs, unlike regular IRAs, have no required minimum distributions once you reach age 70 1/2.

Most retirees fund their Roth IRA by moving (converting) funds from their traditional IRA to their Roth IRA. A conversion isn’t allowed if modified adjusted gross income is greater than $100,000. Because of this limitation, many who were taking required minimum distributions from their traditional IRAs were finding that those distributions were pushing them over the $100,000 limitation and were then barred from converting those funds to the Roth IRA.

The new law allows you to ignore the amount of the required minimum distribution when computing your threshold income. Therefore, many older individuals will be able to grow their Roth IRAs by converting traditional IRA funds.

Of course, most funds converted from a traditional IRA to a Roth IRA are treated as taxable income. Because of the taxability of the conversion, some shy away from moving funds from their IRA to a Roth IRA. But this might be shortsighted. It’s possible to plan your conversions in years when your income in minimized. The use of a Roth IRA as part of an overall estate plan can be very powerful, since the Roth IRA funds can pass through to beneficiaries tax-free. Also, since there is no required minimum distribution, the Roth IRA can be passed on and continue to grow tax-free, possibly for decades.

There are many reasons to look into a Roth IRA. Learn more about it at www.fool.com/ira/ira.htm and www.rothira.com.

Ask the Fool

Q: You recently referred to a company’s fair value. How do you find out what that is? — G.T., Canton, Ohio

A: A stock’s true value is not easy to determine. Smart analysts often disagree when they do their complex calculations. They often use a “discounted cash flow” analysis, which involves projecting future free cash flows and assigning them present values based on a chosen discount rate, which is often the weighted-average cost of capital. (See? We told you it was complex.)

There are simpler ways of estimating a stock’s value, though they remain just that — estimates, based on educated guesses. One very rough method is comparing a firm’s price-to-earnings (P/E) ratio to its growth rate. If the growth rate is much higher, the stock may be undervalued. You might also determine the relationship between the company’s average P/E and the average P/E of the S&P 500 index. If the stock has historically traded at 150 percent of the S&P 500’s P/E, which is currently 10, you might conclude that the stock should eventually hit a fair P/E of 15, assuming that nothing changes.

A simpler approach is just to look up the company’s historical P/E ratio range, which you can do at http://moneycentral.msn.com/investor/invsub/ results/compare.asp. If the stock’s P/E has usually been between 15 and 20 and it’s 25 now, there’s a good chance it’s overvalued.

Don’t rely on any of these methods alone. Always gather lots of information and look at many factors.

Q: If I donate $50 to charity and my company matches that with another $50, what can I deduct for tax purposes? — R.M., Sheboygan, Wis.

A: You may deduct just the $50 that you contributed. Your employer may deduct its contribution, too.

My dumbest investment

Want to invest for the wrong reason? Try going into it because you like the company’s name — or because a friend works for the company. International Harvester was a name I remembered from various films at school about farming. I decided that since we needed farms and it was a great name, I would buy it. Wouldn’t you know, the company soon changed its name, to Navistar. There was a reverse split, too. My 100 shares became 10 and were worth less and less as time went by. I sold at a loss. Meanwhile, my friend had a great job with a company she really liked. I asked if she would buy stock in the company and she said yes, she already had. So I bought 100 shares of Calpine at $35. Earlier this year I sold it for about $3.50 (I think it’s less than that now). Like location is to a business, research is to investment. — Dorothy Miller, Pittsburg, Calif.

The Fool Responds: Right you are. Before investing, study a company’s health, growth prospects, track record, management and competitive strengths.