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August 2010
To Roth or Not to Roth?
Starting in 2010, more people can convert their Traditional IRAs and eligible workplace plan
account assets to Roth IRAs, and for 2010 conversions only, spread the tax cost of the conversion over two years. This is a result of a provision of the Tax Increase Prevention and Reconciliation Act of 2005 (TIRPA). Specifically, the Act does the following:
- Remove income limitations on conversions to Roth IRAs
- Allows those married but filing separately to convert
- Allows taxpayers to defer their tax liability on amounts converted in 2010, paying amount equally over tax years 2011 and 2012
- This provision does not impact direct rollovers form Roth 401(k) and Roth 403 (b) to Roth IRAs which have always been allowed.
While you should not rush into a Roth IRA conversion, there may be several instances where a conversion will leave you in a better financial situation over the long term. When considering if you should convert to a Roth IRA, there are two main subjects to think about; the effect on your finances during the Roth conversion and the effect at retirement.
Consider a Roth if:
- You believe that you will be in a higher tax bracket during retirement. When you convert, the conversion amount will count as income and you will pay taxes on pre-tax contributions plus growth using today’s tax brackets. You will have a larger tax bill up front because you are paying on all of it now, but if you anticipate a rise in overall tax rates or your personal bracket, you will pay fewer dollars in tax by converting in 2010. In addition, paying taxes now and converting means you do not pay on future earnings. However, remember that many people find themselves in lower tax brackets come retirement age.
- You cannot contribute new funds to a Roth IRA. If you are over the Roth IRA contribution limits, you can now contribute to a Traditional IRA and convert each year, but you do not know if the rules will change. Converting what you have now is your best chance to take advantage of the tax breaks offered by a Roth.
- You are over 70 ½ and do not need access to your rollover-eligible funds. IRA account owners must take a taxable minimum distribution each year after attaining the age of 70 ½, but Roth funds can sit in the account untouched until the owners death. If you do not need the income in future years, you can preserve the funds for your heirs by paying taxes on the rollover and letting your funds continue to grow tax free. If you believe your heirs will be in a lower tax bracket after your death, you may want to skip the conversion and let them pay (lower) taxes later instead.
- Your IRA contributions have dropped in value. If you convert funds that have dropped in value, you only have to pay taxes on what you actually convert- even if it is less than you originally contributed. If the stock market continues to rebound from the market lows you will benefit from tax-free growth after conversion. Should the funds continue to go down in value you can do a re-characterization back to a traditional IRA and receive a refund for some of your tax payments.
Hold off or only do a partial conversion if:
- You would tap the conversion amount to pay taxes. In order for a conversion to make sense at all, you must be able to pay the taxes on the conversion amount from outside your retirement funds. Using funds to pay the tax bill lowers the amount of money you have available to grow tax free and withdraw in retirement. Also, you may face a penalty if you are under 59 1/2. If you want to convert your nondeductible IRA contributions, you can by using a special Roth IRA conversion strategy.
- Your conversion amount would place you in a higher tax bracket. If you expect to be in a much lower tax bracket at retirement, it may not make sense to convert now. The final decisions depend on how many years you have until retirement and how much growth you expect. If you are relatively young and expect high appreciation, it may make sense to pay a high tax rate on a lower amount. However, if you only have a few years until retirement, chances are the math for a conversion may not quite work out.
- You want to avoid increased taxation on your Social Security Benefits and/or Medicare premiums. IRA Conversions basically count as income for tax purposes, and for calculating Medicare premiums and the taxation of your Social Security Benefits. Keep in mind these adjustments will only matter for one year, therefore it will not be big factor but one to consider for 2010.
Converting to a Roth IRA is a good idea for some and not for others and figuring out all the possibilities and implications can be a complicated process. Give me a call at 1-888-325-9826 or email me at gscott@wabashcapital.com to discuss in more detail the Roth IRA and other retirement planning options. Working alongside your tax professional we have the tools to assist you in considering the best choice for your personal financial situation.