If you are thinking about converting your traditional IRA to a Roth IRA in 2010, you may want to consider the pros and cons. Below is an informative article about this topic written by Darrell J. Canby.
FINANCIAL SENSE: Roth ‘n’ Roll in 2010
By Darrell J. Canby/Local columnist
November 23, 2009
Unless Congress passes legislation to alter the current law before the end of the calendar year, the potential for Roth IRA conversions in 2010 is vast.
Roth IRA conversions are not new. However, until now only taxpayers whose income was less than $100,000 were eligible to convert traditional IRAs to Roth IRAs. Effective in 2010, there will be no income limitation. As a result, many people should review their situation to determine if a conversion would be beneficial for them and would help them achieve their long-term financial goals.
To determine whether a conversion would benefit you, consider the differences between traditional IRAs and Roth IRAs. Contributions to traditional IRAs are tax-deductible, within certain limits, during the year the contribution is made. Income taxes are deferred on earnings. Income is taxable when funds are withdrawn from the traditional IRA.
For many people, Roth IRAs offer a better opportunity. Funds are contributed on an after-tax basis, but they can grow on a tax-free basis and taxes will never be due on Roth earnings, as long as the assets are held in the Roth IRA for at least five years and any withdrawal occurs after the individual reaches age 59 1/2.
This advantage is especially important because taxes are scheduled to increase.
Earlier in this decade, tax legislation was enacted that, among other things, lowered individual income tax rates and raised the asset level at which an estate would be taxable. The law also provided that the estate tax would be zero in 2010. It then provided that, effective in 2011, individual income tax rates would revert back to pre-legislation levels, the exemption for estate taxes would decrease to $1,000,000 and estate tax rates would increase back to a maximum rate of 55 percent. The same legislation eliminated the income limitation for Roth IRA conversions.
Unless Congress changes the law, taxes will increase automatically. If you pay taxes at a 25 percent rate today, you will be paying at a rate of 28 percent in 2011; the next two brackets will increase by 3 percent as well, and if you pay at the current maximum 35 percent rate, your rate will increase to 39.6 percent.
In addition, further tax increases may be necessary. This year’s deficit alone is projected to be $1.4 trillion. Billions spent on the financial crisis, plus potential spending on healthcare reform, could result in a future tax increase. So your tax rate could be higher in years to come than it is today.
The amount of a Roth conversion creates taxable income. For conversions in 2010, the tax can be paid as part of your 2010 tax return at the rates in effect for 2010. You can also choose to report the 2010 conversion income 50 percent in 2011 and 50 percent in 2012 and pay tax at the prevailing rates at that time. Keep in mind that the rates in 2011 will automatically be higher unless Congress changes the provisions of the current law.
In order to enjoy the tax free benefits of a Roth IRA, there is a waiting period of five years and upon distribution, you must be at least age 59 1/2. So if you execute a conversion on Jan. 1, 2010, you need to wait until Jan. 2, 2015, before taking a distribution to insure the distribution will be tax free.
Advantages of Roth conversions
So what are the advantages of converting to Roth IRAs? Should you convert some or all of your IRA assets to Roth IRAs? Should you convert all in one year or over several years?
It would be wise to consult with your tax adviser to answer these questions, but the following factors are key:
Tax free build-up of converted assets. The major advantage is that all of the growth in value of the Roth IRA from the conversion date will be tax free forever, as long as you meet the five year rule and are at least age 59 1/2 when you take distributions.
Hedge against increasing tax rates. If tax rates increase, keeping your assets in a traditional IRA may mean you will pay higher taxes on the future distributions than the rate you may pay now on the conversion.
The performance of your portfolio. If your portfolio lost a lot of its value in the recent bear market and has not fully recovered, you can save on taxes by converting now, before your portfolio recovers, because taxes will be based on the value of your IRA at the time of conversion.
Allows for tax diversification in the future. You could take a portion of your income needs from a traditional IRA and some from the Roth IRA to avoid going into a higher tax bracket. You can also use this flexibility to keep the taxation of social security to a minimum and to potentially lower your costs for Medicare.
Increase in taxable income could absorb losses. Some people have experienced business losses in their S Corporation, partnership or LLC that could be used to offset the income associated with a Roth conversion. There also may be some people that have large charitable contributions that were limited due to their income. The income associated with a Roth conversion could be offset in part by these deductions.
Required minimum distribution eliminated. When you reach the age of 70 1/2, you are required to take a minimum distribution from your retirement assets in most cases. Required minimum distributions were relaxed in 2009 due to the financial crisis. Minimum distributions are not required for Roth IRAs. Some people do not wish to take distributions, because they want them to grow for the benefit of their heirs. Roth IRAs allow taxpayers to save for this objective.
Your age. If you’re young and have many years until retirement, Roth IRAs are especially attractive, because your investments should be able to grow tax-free for many years before you use them.
Legacy asset. If you leave your children a traditional IRA asset, they will be responsible for income taxes as they make withdrawals. If they inherit a Roth IRA, there will be no income taxes, so it will be less of a burden on their children.
Disadvantages of Roth conversions
While it is important to consider all of the potential advantages of Roth IRAs, you should also be aware of the disadvantages.
Immediate tax cost. There is an immediate tax cost that reduces your investment assets available for your retirement.
Tax at a higher rate. The conversion amount produces income that may cause the effective tax rate to be higher, due to phase outs of certain deductions.
Insufficient assets outside of retirement plans to pay the tax. The general rule is that you do not want to use retirement plan assets to pay the tax associated with a Roth conversion. So if you do not have assets outside of retirement assets, you probably should not consider a Roth conversion. As with any of this advice, you should consult a tax professional to be sure.
Tax rates will be lower in retirement. Your situation may suggest that your income tax rate may be lower in retirement. You would not want to pay tax now at a higher rate than you would otherwise be paying in retirement.
Need to have distributions prior to five-year waiting period. If you will need to make withdrawals from your IRA assets within five years, you will not want to have to use any converted assets. Keep enough assets outside of the Roth to avoid such a withdrawal need from that account.
Your age. If you have attained a level of maturity that would limit the amount of time for the tax-free benefits, you may not have a significant advantage from a conversion.
Your tolerance for risk. If your IRA money is invested in low-interest certificates of deposit or other investments that are expected to earn little, you’re likely better off keeping your money where it is and deferring taxes.
An IRA that was converted to a Roth IRA can be recharacterized back to a traditional IRA before a timely filed tax return. For example, if you converted $10,000 of your traditional IRA to a Roth IRA on Jan. 15, 2010, you could convert that back to the traditional IRA by April 15, 2011, (or as late as Oct. 15, 2011, if you filed a proper extension of time to file your 2010 return). So if you did execute a conversion and decided it was a mistake, the opportunity to convert back is available. A timely recharacterization avoids paying the tax on the conversion.
This is a complex area with many implications. Therefore it is best to consult with your tax adviser before making any moves. Weigh the advantages and disadvantages to determine if a conversion is in your best interest.
It may be best to convert some, but not all, of your retirement assets to Roth IRAs. One reason is to start the five-year waiting period, because once it is completed you can alleviate that requirement on conversions in the future.
Another reason to have both a taxable IRA and a non-taxable IRA is that it allows you to combine the two as part of a tax strategy to lower your overall taxes. Taxes on 401(k) plans and traditional IRAs, for example, are deferred until income is distributed. You can take income from these tax-deferred retirement accounts up to the point where you would be entering a higher tax bracket, and then you can take additional distributions from your Roth IRAs without incurring additional taxes.
For many taxpayers, it will make sense to convert as much as possible to Roth IRAs in 2010. The younger you are when you convert your IRAs, the longer the timeline during which they will be able to grow tax-free.
Congress will be looking for new sources of revenue, thus rules for Roth IRAs could change, making them less attractive. Roth IRAs may be too good to last.
Darrell J. Canby, CPA, CFP@, is president of Canby Financial Advisors, LLC, a registered investment adviser at 161 Worcester Road, Suite 408, Framingham. He offers securities as a Registered Representative of Commonwealth Financial Network, Member FINRA/SIPC. He can be reached at 508-598-1082 or email@example.com.
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