traditional ira

2010 Roth Conversion: Good Idea?

by J.J. on November 17, 2009

Over the next couple of weeks, six finalists will be auditioning for the opening of “staff writer” at Consumerism Commentary. Each will be providing two guest articles to share with readers. After the six writers have shared their guest articles, readers will have an opportunity to provide feedback before we select the staff writer.

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.

Why 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.

Nondeductible contributions

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.

Estate planning

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?

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Roth IRA Conversion

by Flexo on August 21, 2009

The option to convert a Traditional IRA to a Roth IRA has been around for a while. Here are the differences between a Traditional IRA and a Roth IRA for those new to these retirement accounts. As long as your modified adjusted gross income (MAGI) is under $100,000 you have qualified for this conversion. Contributions to the Traditional IRA is tax-deductible, which means that your tax bill is calculated after ignoring the amount you deposit into the IRA. You will pay those taxes after you retire and begin withdrawing these funds. If you have a higher tax rate now than you will in retirement, the Traditional IRA is a good choice.

On the other hand, the Roth IRA is not tax-deductible, so the deposits into this type of IRA are not exempted from your total income calculation for tax purposes. In effect, you use “after-tax money” to invest in a Roth IRA. This is a great choice for people who believe their tax rate now will be lower than it will be in retirement once they begin taking distributions.

There are two other benefits to the Roth IRA that often go unnoticed. The Roth IRA does not require distributions after age 70 1/2 like the Traditional IRA, offering more flexibility in retirement. The Roth IRA is better for estate planning; choosing a Roth IRA rather than a Traditional IRA for funds passed onto your heirs will allow them to avoid tax bills.

These benefits come with a drawback: if your MAGI is above $105,000 ($166,000 for those who are married filing jointly) your maximum allowed contribution begins to reduce and will completely phase out at $120,000 ($176,000 for married filing jointly). But there is now a law that will help you get around this for a short time.

In 2010, the $100,000 maximum for Roth IRA conversions will temporarily disappear. If you believe the Roth IRA is a better option for you but you have been prevented from investing in this type of account due to income limitations, now is your chance to make the change. Here is why this will be allowed: When you convert from a Traditional IRA you owe taxes on the amount of the conversion, and the government would really like that income.

If you must pay those taxes using funds from your IRA, the conversion might not be a good idea, but if you have cash saved for the tax bill you will be better off.

You can also convert accounts known as SEP IRAs and SIMPLE IRAs.

Here are some quality resources regarding Roth IRA conversions.

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Traditional vs. Roth IRA: An Introduction and Comparison

by Flexo on March 11, 2009

The Individual Retirement Account (IRA) allows anyone who earns income the opportunity to save for retirement, regardless of the plans offered by his or her employer. An IRA is not an investment in itself, it’s an account type. Within the IRA, you can keep your money for the future in money market funds, CDs, stocks, even gold. The government limits how much you’re allowed to invest in an IRA each year. Here are the contribution limits for 2009. In addition, the government also reduces these contribution limits for certain types of IRAs depending on your income. For individuals over the age of 50, the government raises the contribution limit to help “catch-up.”

Traditional and Roth IRAs

There are two main “flavors” of IRAs: traditional and Roth. Both types include the benefit of allowing money to grow tax-free while invested and untouched. That means that even while your account grows, you won’t have to pay taxes on capital gains or interest. That leaves more money in the account, with returns possibly compounding upon returns. A traditional IRA adds the benefit of tax-deductible contributions. In other words, if you contribute $5,000 to your traditional IRA, if you aren’t excluded by your level of income, you can deduct the $5,000 from the income you report on your tax return. You will pay tax, however, when you are retired and take a distribution from the account.

Contributions to a Roth IRA are not tax-deductible. The most common way of describing this is that you invest in Roth IRAs with “after-tax” money and traditional IRAs with “pre-tax” or “before-tax” money. When you take a distribution from your Roth IRA after you’ve retired, you will not pay tax on your capital gains, of which the plan is to have many.

You can withdraw money from an IRA at any time, but if you do so before age 59 1/2, you may face some penalties. First, with a traditional IRA, you will be taxed on your contribution and gains withdrawn, plus be subject to a 10% penalty in the form of a tax for “early withdrawal.”

Which IRA to choose?

In general, when deciding between a Roth IRA and traditional IRA, the choices comes down to your tax bracket. If you think you have a lower tax rate now than you will when you retire, the Roth IRA will keep you from paying tax on your contributions when you withdraw after age 59 1/2. If you think you will have a lower tax rate in retirement, take the deduction in a traditional IRA now and pay the tax on contributions when you withdraw after 59 1/2. Sounds simple, right? There are a lot of variables to consider. For example, will this country’s tax rates be much higher by the time you retire?

More importantly, will the government decide to change the tax advantaged status of these accounts, and will that change affect current investors, before you reach retirement? Many people hedge their bets on the future tax rates by investing a portion of their maximum allowed contribution in a traditional IRA and the remaining portion in a Roth IRA.

There are numerous nuances to consider as well. If your income is too high to qualify for a Roth IRA right now, you can contribute to a non-deductible traditional IRA and “recharacterize” the IRA as a “Roth IRA” by paying taxes next year, regardless of your income level in 2010. There are certain circumstances in which you can withdraw your money from a Roth IRA without paying the 10% penalty. Using your Roth IRA to pay for your first house is one of the qualifying cases. Furthermore, you can re-contribute to a Roth IRA if you withdraw your contributions.

If you’re self-employed, even if only as a side job to complement your main career, you can also contribute to a SEP IRA as your own employer. This greatly increases the amount you can save for retirement.

Setting up your initial IRA

I find it important to look for low-cost investments for IRAs. Since they are tax-advantaged — you don’t pay taxes on gains and interest while your money stays with the IRA — you can freely trade without having to report your income to the government, leaving more money working for you. For the last few years, I have been using Vanguard exclusively for my IRAs. They have low cost index funds and solid money market funds available. The account opening process is straightforward, and once your initial account is active, it takes only a few clicks to contribute, transfer money from one fund to another, and create automatic investment plans.

Another popular company for IRAs is Fidelity.

This is only n introduction to Individual Retirement Accounts. Please feel free to share any tips you have or experiences you’ve had with IRAs.

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Traditional and Roth IRA Contribution Limits for 2009

by Flexo on January 1, 2009