Roth IRAs are very trendy right now. “Trendy” isn’t a word I usually use to describe financial products and services but in this case I think it applies. Many investors are so concerned about upcoming tax rate hikes that they are more than willing to forego a tax deduction today if it means not having to worry about rising rates in the future. Starting in 2010, anyone can convert a traditional IRA to a Roth. SEP and SIMPLE IRAs can be converted as well. Before 2010, only individuals with adjusted gross incomes below 100K could do the Roth conversion. So, this opens the door for lots of wealthier Americans to make this switch. No surprise the government is looking for new sources of tax revenue now as they have plenty of fiscal problems to deal with. Below is a list of questions I’ve been fielding regarding IRAs and the Roth conversion.
What are the core differences between traditional and Roth IRAs?
Traditional IRA contributions are always tax deductible if neither you nor your spouse is actively participating in an employer-sponsored retirement plan such as a 401k. So, here’s a simplified example: If you earn $50,000 and put $5,000 in a traditional IRA, you’d pay taxes based on $45,000 instead of $50,000. This can increase your tax refund if you have substantial tax withholdings from your gross pay. Again, the main benefit with a traditional IRA is a tax deduction now, and you pay income tax on your money when you eventually take distributions, presumably later on during retirement.
Roth IRA contributions are made on an after-tax basis and are not taxed when withdrawn. So you don’t get the tax benefit now, you get it later. Like a traditional IRA, Roth IRA investment earnings accumulate without having to pay current taxes on them. However, as opposed to a traditional IRA, qualified withdrawals of Roth IRA earnings are tax free.
Why would you want to convert to a Roth IRA?
A Roth IRA can provide tax-free income after you retire. And, unlike distributions from a traditional IRA, qualified Roth distributions are not included in income for purposes of determining whether Social Security benefits are taxable. Also, traditional IRAs require distributions once the account holder reaches age 70 ½, increasing the likelihood that Uncle Sam can take a bite out of your earnings while you are still alive. Roth IRAs do not have minimum required distributions, allowing the account to (hopefully) grow on a tax-deferred basis for longer. Beneficiaries do have to take distributions but those are still not subject to income taxes so long as the Roth has been in existence for 5 years.
What are the tax consequences of converting a traditional IRA to a Roth IRA?
This is the sting. When you convert to a Roth, any deductible contributions you made and any accumulated earnings in the traditional IRA become taxable. However, even if you’re younger than age 59 ½, you won’t be liable for the 10% early withdrawal penalty on the conversion. Lucky for investors, if they convert in 2010, they can split the tax bill over two years, 2011 and 2012. This may soften the blow a little for taxpayers and make it possible for some less wealthy investors to convert to a Roth. You don’t have to split the tax over two years but you have the option.
Who should consider a Roth IRA conversion?
Like most things in this business, the conversion decision is very personal because everybody’s situation is different. In general, you will likely benefit from a Roth IRA conversion if:
• You think you’ll be in the same tax bracket or higher in the future—even when you retire.
• You have a low account balance now but expect the value of your account to be significantly higher in the future.
• The younger you are, the more likely you are to benefit (time value of tax-deferred investment accounts).
• If you don’t think you’ll need all of your retirement savings, converting to a Roth could potentially allow you to provide your beneficiaries with tax-free income.
• If you have the resources to pay the conversion tax not out of your IRA. This is why people with savings outside of their IRA accounts (generally people with slightly higher incomes) will often stand to benefit more from the conversion.
What if I convert and then my account value drops?
This is an important question to answer because it poses what could end up being an unfortunate scenario. Let’s say you convert 50K and then your account value drops to 40K, you would indeed have to pay income taxes based on the balance at the time of conversion (50K). If it drops and you change your mind about the conversion, you can recharacterize back to a traditional IRA and no longer owe tax on the conversion. For this reason, it makes sense to wait until the latest possible date to covert. Recharacterizations can be processed until October 15th of the year following when you convert.
Because going through the Roth conversion will increase your tax bill, consider the effect it may have on your overall tax situation. You may have other credits/deductions which you can’t take as a result of pushing your AGI higher with the conversion. I know that’s a tricky thing to think about, but programs like Turbo Tax makes it easy to try various scenarios and see what works best for your situation.
Questions or comments? Feel free to call or e-mail me.
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