Now is an ideal time to become familiar with the benefits and drawbacks of converting a traditional IRA to a Roth IRA. Currently, only households with a modified adjusted gross income (MAGI) of less than $100,000 can convert, but this income limit will be waived in 2010. Consider these key factors to determine if this strategy is appropriate for your circumstances.
Why Convert?
Before converting your traditional IRA into a Roth IRA, ask yourself whether you anticipate being in a lower, higher or the same tax bracket during retirement? If retirement withdrawals or other sources of income will keep you in the same or higher tax bracket, why not pay taxes on your retirement account now so you can enjoy the benefits of a lower tax rate? This is exactly what a Roth conversion allows you to do. Here are three more tax implications to consider:
1. Tax rates are incredibly low by historical standards. Most experts anticipate tax rates to increase in the near future to allow the government to fund liabilities such as Medicare, Social Security, and the economic stimulus package. If rising tax rates are a concern, why not convert a traditional IRA to a Roth, pay taxes at today’s low rates and enjoy tax-free growth going forward?
2. Converting now, after asset values have dropped 40%, will minimize taxes. Investors will only pay taxes on today’s deflated values, which is more cost-efficient than paying taxes on 2007 investment values.
3. The government does not require minimum distributions from Roth IRA accounts. This enables money to continue to grow tax deferred for as long as possible. At death, a Roth IRA transfers to heirs tax free; a traditional IRAs does not.
Other Factors
Investors who convert in 2010 have the option of splitting the tax bill between 2011 and 2012. When converting, ALWAYS pay the tax liability with other income to keep as much money growing tax-free as possible. Lastly, be conscious of IRA conversion distributions lifting you into a higher tax bracket. An investor can partially convert an IRA during multiple years to avoid a large infusion of income in a single year.
Poor Timing Can’t Hurt You
What if an investor converted to a Roth IRA in early 2008 when values were high? Unfortunately, the tax bill is based on the value of the assets when the conversion took place, which means a tax liability likely exists on money that has since been lost.
Thankfully, that ill-timed conversion can be reversed through a process called recharacterization. Recharacterizing makes it like the conversion never happened, and the inflated tax bill simply disappears. The IRS will allow Roth conversions to be recharacterized until October 15th of the year following the transaction.
However, if converting a traditional IRA to a Roth IRA was a good strategy before, a conversion still likely makes sense. Fortunately, after recharacterizing back to a traditional IRA to minimize a tax bill, an investor can elect to convert the account back into a Roth at the beginning of the year following the initial conversion, or if the year has already ended, 30 days after the recharacterization.
This strategy provides protection if investment values continue to decline. Thus, don’t delay converting to a Roth out of fear the market has yet to hit bottom.
Potential Pitfalls
Converting a traditional IRA to a Roth IRA is likely not beneficial for investors who believe they will be in a lower tax bracket during retirement than during their working years. After all, why pay taxes now at a higher tax rate to avoid having to pay taxes later at a more favorable rate?
Another group that may not benefit from a Roth conversion are individuals who will likely have a large amount of itemized deductions on their federal tax returns during retirement. Itemized deductions such as mortgage interest, health care costs (only amounts over 7.5% of adjusted gross income can be deducted), state taxes, and donations can be used to offset income. The IRS does not consider withdrawals from a Roth IRA to be income, so itemized deductions cannot be used to offset Roth distributions. Conversely, itemized deductions can be used to offset traditional IRA distributions.
For example, an individual who converts to a Roth IRA and then has a large amount of medical expenses later in life would ultimately pay taxes up front and fail to take advantage of itemized deductions which would have reduced income taxes on traditional IRA withdrawals. In this case, the individual would have been better off deferring income taxes until he or she had itemized deductions to offset income from traditional IRA withdrawals.
Not sure of the value of your future itemized deductions? A great strategy would be to convert a portion your traditional IRA to a Roth IRA to achieve “tax diversification.” A tax diversified individual would have the option of withdrawing money from a traditional IRA account in years when there were itemized deductions to offset the income, or taking tax-free withdrawals from the Roth account in years when itemized deductions were not available.
Lastly, what if the federal government has a change of heart about the tax free status of Roth IRAs? If everyone converts to a Roth now, the government will experience a decline in revenues from traditional IRA and 401(k) withdrawals down the road. To meet its obligations, the federal government could potentially begin taxing the gains on these Roth accounts. Of course, no one knows the future, but this is another area where tax diversification can be useful. A portion of a tax-diversified investor’s portfolio could still be tax free if rules governing Roth accounts remain the same, while the investor won’t have all his eggs in one basket if an unforeseen rule suddenly makes Roth accounts less appealing.
Bottom Line
Everyone should at least consider a Roth IRA conversion during the next year and a half. Many factors can make these conversions more or less appealing, so it’s best to speak to a financial planner with a fiduciary obligation to do what is in their client’s best interest to determine if this strategy would be beneficial for your situation.
Lon Jefferies is an investment advisor representative with Net Worth Advisory Group, a fee-only financial planning and investment advisory firm in Salt Lake City, Utah.
He specializes in developing custom financial plans, implementing investment strategies, and providing ongoing support and service in order to help clients reach their financial goals. He can be contacted at (801) 566-0740 or lon@networthadvice.com.
Visit the Net Worth Advisory Group website at http://www.networthadvice.com and read Lon’s blog at http://www.utahfinancialadvisor.blogspot.com.
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