| Most of us are not very happy about the performance of our investments. But if you are looking for a bright spot, it’s not a particularly bad time to consider converting a traditional IRA to a Roth IRA.
Right now, anyone with modified adjusted gross income of less than $100,000 a year (individual or joint income) can convert a traditional IRA account to a Roth IRA. You can also convert a 401(k) from a previous employer. Higher-income Americans will get the same break in 2010 if Congress doesn’t reverse its 2006 approval of provisions in the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). For many people, this may be the tax planning event of a lifetime.
Keep in mind that this also might be a good idea for people who were unemployed or disabled during the past year and therefore had lower income. Talk to your tax professional about doing a full or partial Roth IRA conversion.
Remember that when you do a conversion, you must pay income tax on the amount you are converting, which can be all of the funds in the traditional IRA or just a portion of those assets. But, subject to certain restrictions, you won’t pay tax when you finally need to withdraw your money. That’s where the silver lining comes in for you or for your heirs if you pass that money on to them.
Take another look at your statements and how much your investments are down. Assuming that the markets perform historically and fight their way back, your tax-free amount available for withdrawal could accumulate significantly under that Roth status.
The conversion issue is a potentially attractive retirement and estate-planning idea for all Americans who want to make sure they maximize the assets they have for themselves and for their heirs on a tax-free basis. But anyone considering such a move-regardless of his or her income status- should first review their current retirement asset strategy with a tax or financial adviser such as a CERTIFIED FINANCIAL PLANNER™ professional.
Things to consider:
The difference between a traditional IRA and a Roth IRA: Traditional IRAs allow investors to save money tax-deferred with deductible contributions (within certain income limits if either spouse is eligible for a qualified plan at work) until they’re ready to begin withdrawals anytime between age 59 ½ and 70 ½. Roth IRAs don’t allow tax-deductible contributions, but they allow tax-free withdrawal of funds with no mandatory distribution age and allow these assets to pass to heirs tax-free as well. If you leave your savings in the Roth for at least five years and wait until you’re 59 ½ to take withdrawals, you’ll never pay taxes on the gains. You can convert a traditional IRA to a Roth, but you must pay taxes on any pre-tax contributions, plus any gains.
Pay taxes over time: If you convert your traditional IRA to a Roth in 2010, the new rules allow a payment plan. Half of the tax will be due in 2011 and the other half will be due in 2012. This is the equivalent of a tax free loan from the US Treasury. This benefit is only available for conversions done in 2010.1
Time to retirement matters: If you have more than five years until you plan to withdraw your retirement funds, conversion of traditional IRA assets to a Roth IRA might make sense. The longer the time span where earnings can grow tax deferred, the greater the benefit of being able to withdraw those earnings without paying tax on them.
Your tax rate at retirement is important: It is very likely that the US Government will be raising taxes in the future to pay for all the benefits it is currently providing. Additionally, with Social Security benefits being taxable at certain income levels, Roth IRAs can allow you to limit or eliminate such taxes.
A Roth conversion can be expensive: You’ll have to pay taxes on contributions that you previously deducted, as well as taxes on the accumulated earnings. Also, you need to be aware that conversion could push you into a higher tax bracket. This is why a conversion needs to be planned with a tax expert. Why? It may trigger the Alternative Minimum Tax (AMT) due to those high earnings.
Distributions to beneficiaries: For a non-spouse beneficiary generally, the entire interest in the Roth IRA must be distributed by the end of the fifth calendar year after the year of the owner's death unless the interest is payable to a designated beneficiary over the life or life expectancy of the designated beneficiary.2
Imagine this: You are 60 years of age and you have $50,000 in a traditional IRA that you believe you will never need to spend in your life time. You convert this traditional IRA to a Roth IRA and pay the taxes due from other funds and you name your adult child as the primary beneficiary. Let’s presume that this Roth IRA, at the time of your death at age 85, has grown to be worth approximately $275,000. Your adult child would be required to take tax free minimum distributions either over the five years after your death or over their life expectancy. What a wonderful legacy you have left behind.
I’m sure you have all heard that saying before and in today’s economy I guess there will be a lot of us making lemonade.
This column is produced by the Financial Planning Association, the membership organization for the financial planning community.
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