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Over the coming months, investors are going to be bombarded with articles, news stories, radio reports, advertisements, seminars, and financial press about a “big opportunity” that is coming on January 1, 2010.
Courtesy of the Tax Increase Prevention and Reconciliation Act of 2005, all owners of traditional and rollover IRAs will be allowed to convert these accounts to Roth IRAs. Under today’s rules, anyone with a modified adjusted gross income in excess of $100,000 isn’t allowed to make this conversion. But on January 1st, the income restrictions go away and the conversion opportunity is available to everyone. Investors may convert their existing eligible IRAs by paying ordinary income taxes on the amount they wish to convert and rolling over the amount to a Roth IRA. The 10% premature distribution penalty for withdrawals before an investor reaches age 59 ½ does not apply.
A reminder about how IRAs are taxed should help us understand why a consideration of the opportunity to convert is warranted by all owners of traditional IRAs.
While contributions made to traditional IRAs are deductible and grow tax-deferred (you don’t have to pay tax on the interest or capital gains), the “tax man cometh” in the years when you take withdrawals. This is because withdrawals and distributions from traditional IRAs are taxed, just like ordinary income.
While Roth IRAs also accumulate tax-deferred, the contributions made to Roth IRAs are not deductible. But, here’s the big draw to the Roth: distributions (under most circumstances) are tax-free. So assuming you invest wisely, investors with money in Roth IRAs will have a big nest-egg and it’s all theirs with nothing due to Uncle Sam.
So, the 2010 conversion opportunity is significant because it gives retirement savers an opportunity to pay taxes now on the money in their IRA at its current value, in exchange for what could be decades of tax-deferred compounding and tax-free withdrawals during retirement. Imagine a snowball rolling downhill!
Converting an IRA in 2010 may also help quiet one of the common grumblings of many traditional IRA owners: the forced distributions they must begin taking when they turn 70 ½. These required minimum distributions don’t apply to Roth IRAs. Converting in 2010 allows investors to continue growing their Roth IRA assets, tax-free, for many more years. And beneficiaries of Roth IRAs pay no income taxes when they cash out of inherited Roth IRAs. And of course, proper beneficiary planning can allow beneficiaries to stretch distributions over the beneficiary’s lifetime.
Conventional wisdom has been to defer income taxes whenever possible, and delay withdrawals or distributions from tax qualified accounts, until retirement (when marginal tax rates are expected to be lower during non-working years)… but many are reconsidering due to concerns over the possibility that tax rates may increase in the years ahead. Higher income tax rates in future years may make the conversion even more attractive. Even at a quick glance backwards, we remember that today’s marginal tax rates are at historically low levels. So, a conversion in 2010 may provide investors an opportunity to lock-in today’s tax rates.
Another reason for considering a conversion is due to the market downturn of the last year and half. By converting in 2010, the income tax due is calculated based on the current reduced value of the IRA and allows future growth to accumulate tax free as the economy and markets recover. If you have any old 401(k)s or other retirement plans from a previous employer, those may also be allowed to convert.
If you can’t pay the income taxes from cash sources outside of your IRA, you probably shouldn’t convert. The main reason: the loss of future earnings on money that would have been accumulating tax-free. Fortunately, conversion in 2010 allows investors to spread out their tax payments over 2011 and 2012, with 50% of the tax being paid in each year.
If the Traditional IRA includes any non-deductible contributions, these assets may be converted tax-free. If the entire IRA is converted, the total of all non-deductible contributions are subtracted from the total value before the income tax is calculated. For a partial conversion, the tax is pro-rated based on the amount represented by the non-deductible portion.
IRA Owners who are considering giving their IRA to a charity might be better of leaving traditional IRAs alone, because charities don’t pay taxes on withdrawals from gifted IRAs. For investors with sizable estates, they might consider splitting IRAs, one to convert to a Roth and the other for the charity. Partial conversions may prove to be one of the most popular choices next year. By converting a portion of a traditional IRA, investors may protect themselves against higher future tax rates, while allowing the unconverted IRA to continue in the event rates do not increase. Much like we encourage clients to diversify their assets, this tax-diversification method may be an attractive strategy.
Investors should consider current and future income tax rates, investment returns, income, family dynamics, and marital status. And most importantly, investors need to think about their intentions for what to do with the money in their retirement accounts. This is not a one-size-fits-all, “everyone should do it” opportunity. To-convert, or not-to-convert a Traditional IRA to a Roth IRA, is a financial planning decision that should be made only after careful review of your individual situation with your tax counsel and trusted advisors.
Chad Carlson, CFP®, CERTIFIED FINANCIAL PLANNER™, is a Vice President with Delta Trust Investments, Inc. in Little Rock, Arkansas. Chad may be reached at (877) 467-9610 or ccarlson@delta-trust.com. |
