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Posts Tagged ‘Roth IRA Conversion’

Lots of ink has been spilled discussing one of the most hyped retirement and tax strategies: Roth IRA conversions.  The prospect of future tax-free withdrawals is enticing.  But there are lots of issues that need to be considered whether it is right for you.

According to Google, there has been a surge in interest about Roth IRA conversions as it has become one of the top search terms this fall. (1)

This is hardly surprising considering that starting in 2010, all taxpayers, regardless of income, are eligible to convert tax-deferred retirement assets to a Roth IRA.

Prior to the change, the law prevented taxpayers with household incomes above $100,000 from converting assets to a Roth IRA.

Starting this year, tax code changes allow conversions of other tax-deferred retirement accounts regardless of income. This broadens the opportunity for those who did not have these choice before. It should be noted that there are still annual income limits in place for determining eligibility to contribute to a Roth IRA. (There are no limits to use a Roth 401k provision in your employer’s plan).

The majority of Americans believe their own taxes are going to increase.  Given government deficits and entitlements for an aging workforce, taxes may certainly be needed to cover these commitments.

As it stands, tax rates are scheduled to increase in 2011. Unless Congress acts to delay reversion to the prior tax rates, taxes on Roth IRA conversions will be higher after 2010.

A Roth IRA conversion offers an opportunity for future tax-free income.2

But does it make sense?

Does Roth Conversion Make Sense

Whether or not a Roth conversion makes sense really depends on an individual’s circumstances.

Money in all types of tax-deferred accounts like IRAs, 401ks and such are all jointly owned by the participant and Uncle Sam as silent partner.

Although the tax tail shouldn’t wag the dog, you should cut the best deal with the least impact on your personal tax situation.

It makes the most sense for those who expect to have more than enough assets and income for retirement and don’t want to be forced to take Required Minimum Distributions (RMDs) on IRA accounts.  It also makes sense for estate planning purposes as a way to build a multi-generational legacy of tax-deferred wealth accumulation.

And for most who believe that their marginal income tax rates in retirement will be higher whether because of tax policy or because of their own success with work and investments, then it may make sense to lock in the tax liability now.

It also makes sense for those who expect a low income year in 2010 because of retirement or unemployment for example.  Being in a lower tax bracket may reduce the tax bite on the converted funds.

While income and earnings may be withdrawn in retirement tax-free, an investor will still need to pay Uncle Sam now for that future privilege.

And all of this analysis assumes that Congress doesn’t change the rules down the road and even tax Roth accounts.  Consider the fact that during the 1980s, Congress changed the rules about taxing Social Security benefits.

Keeping that in mind, it still may make sense as a way to hedge against future tax policy to do a partial conversion of some of your tax-deferred retirement accounts especially if you have money from non-IRA accounts to tap.

If you use the funds from the tax-deferred account and you’re younger than 59 ½, you’ll be hit with an early withdrawal penalty and your investment will be starting from a lower base making the payback of the strategy more complicated.

Because the tax is assessed on the gains in the account, an ideal time to do this and minimize the tax impact is when account values are off their highs.  With the gains over the past year, this may make a conversion less attractive.

Another thing to consider is that by doing a conversion, your adjusted gross income will increase and potentially result in loss of COBRA subsidy or education credits which are subject to income phase outs.

You Can Change Your Mind Later

Unlike most things in life, you can get a “do over” called a recharacterization that converts everything back to the way it was. The assets would be converted back to tax-deferred status and you can file an amended tax return seeking a refund of the income taxes you paid on the conversion.

Roth IRA conversions offer the potential for tax-free income in retirement for taxpayers at all income levels. If you want more information about converting to a Roth IRA, call 617-398-7494 or email today.

It’s critical to review your individual situation before making a decision about moving important assets.
1) InvestmentNews, November 16, 2009
2) Rasmussen Reports, September 3, 2009

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