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This article is presented by J.J., a financial adviser and published financial author.
Roth IRA conversion rules are changing next year. Even if you make more than $100,000, you’ll be allowed to convert Traditional IRA money into after-tax Roth money. You can even spread the tax payments out over a few years to make it easier if you convert during 2010.
Does it make sense to do so?
We’ve touched on the 2010 Roth conversion rules before. Let’s dig deeper into why it may or may not make sense to convert.
The 2010 conversion rules may help some taxpayers. In general, the opportunity is more attractive if:
- You think tax rates are headed higher
- You’ve been making nondeductible IRA contributions
- You have a high net worth or you want to leave more for your heirs
- You want to diversify the tax status of your money, just like you diversify your investments
Higher tax rates
With higher tax rates in the future, you can get your tax payment out of the way now — at a lower rate. What might make tax rates higher in your retirement years? You could have higher earnings, lawmakers could raise tax rates overall, or both.
With all the talk of government bailouts and broken entitlement systems (like Social Security and Medicare) it’s easy to see why rates could go up. The government needs money, but the solution may not be as simple as an income tax rate increase. There are other ways they can drum up cash:
- Consumption or value added taxes (VAT)
- Change how much you and your employer pay for Social Security
- Change limits on retirement plan contributions
- “Forget” to change certain limits with inflation (IRA and retirement plan contributions, compensation recognized for Social Security and retirement plan calculations, etc)
- Change the laws and make Roth distributions taxable (or potentially taxable, like Social Security benefits)
- Other strategies I’m not smart enough to understand
If you’re betting on higher tax rates, make sure you understand how the bet can go wrong.
If you’ve been making nondeductible contributions, you’ve practically made Roth contributions anyway. In fact, you probably couldn’t deduct the contributions because you make too much money. For you, the conversion option is worth investigating because it would allow you to get the earnings out tax-free – as opposed to just the contributions.
Ideally, you’ve been making nondeductible contributions in recent years, and you have little or no earnings in the account after the recent market decline (sometimes there’s a silver lining). If so, the tax hit may be minimal. However, you should look at all your IRA accounts in aggregate to figure out how much it’ll cost.
Diversify, diversify, diversify
Diversification is another decent reason to consider converting. Most people have all (or a majority) of their retirement savings in Traditional pre-tax accounts. They’ll have to pay income tax as they spend that money. Since we don’t know what tax rates will do, it may make sense to hedge your bets.
If you have a choice of funds (pre-tax and post-tax) in retirement, you can choose whether or not to increase your tax bill in a given year. Suppose you do some consulting work and earn money – it may make sense to take a Roth distribution that year. On the other hand, you can take Traditional distributions when you have little or no taxable income.
If you’re fortunate enough to have an estate planning problem — or just more money than you need — then Roth money can come in handy. By converting, you pay taxes today so your heirs can take tax-free distributions (unless they change the rules and start taxing Roth distributions, of course). You also remove money from your estate when you pay the tax bill.
You’re required to take distributions from Traditional IRAs during your lifetime, starting after you reach age 70.5. The government wants you to generate some tax liability on all that money you’ve been protecting, so they force you to dribble it out over your remaining years. Roth IRAs do not have this requirement, so you can leave more for your heirs.
Proceed with caution
If the idea attracts you, don;t rush into anything. In the coming months, we’ll learn more about the complexities of the 2010 conversion rules, and how the landscape may change (for example, will tax rates increase in 2011 and 2012 — making it less attractive to spread the payments out?). Unless tax rates in your retirement years increase substantially, you probably won’t hit a home run by converting. However, you might come out ahead or just enjoy having more flexibility in retirement.
Remember that if you earn over $100,000, you’re already in a fairly high tax bracket (at today’s rates at least). A conversion won’t be cheap, and you should pay the taxes due from savings available to you outside of your retirement accounts.
Give your eyes a break and listen: a recent Consumerism Commentary podcast has more insight into the 2010 conversion rules.
Will you take advantage of the Roth conversion rules next year? Why or why not?
Published or updated November 15, 2009. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.