New regulations make 2010 an excellent year in which to convert a regular IRA to a Roth IRA. The only caveat is that you must pay taxes on the total amount you convert if that amount was funded with pre-tax dollars.
New for 2010:
- People with modified adjusted gross incomes (“MAGI”) of $100,000 and up, including those using the filing status of married/separate, can now convert a regular IRA to a Roth.
- You can spread income tax payments on the amount converted over two years (for 2010 only) with no taxes due until 2011 & 2012.
- This means that higher income households (over $160,000) can contribute to a Roth by investing first through a standard IRA with after-tax dollars and then converting that account to a Roth. Result? No tax liability.
- You pay taxes on the pre-tax account to-date and avoid ordinary income taxes when you withdraw the money. This is the crucial point about a Roth IRA. It grows tax-free and it is tax-free money upon withdrawal.
- Since the value of your portfolio has been reduced by negative returns, you will owe less in taxes than you otherwise might have had to pay.
- Upon retirement, there is no minimum distribution requirement for funds held in Roth IRAs. You may keep the account fully invested until you need it.
- Younger, lower-income savers who convert and pay taxes now may avoid paying taxes at a higher bracket upon retirement.
- The younger you are, the more years your Roth will grow tax-free.
Who will benefit: Anyone with a regular IRA account, also some individuals currently invested in 401ks whose companies allow for 401k conversions. Some plans require that the participant be over the age of 59½ to make a 401k-to-Roth conversion.
You can do the conversion yourself using forms provided by your mutual fund company. You can convert all, or just a portion of the funds you now hold in a regular IRA, something you might want to consider if the tax bite is too great to allow for a conversion of the full amount. By the way, this would provide an opportunity to review your current investment allocations.
Pay Taxes with Non-IRA Funds
In the interest of maximizing your nest egg, pay the tax with non-IRA assets. Bankrate.com says, “If you do not have adequate funds outside of your IRA to pay the tax liability on a conversion, you probably should not consider converting your Traditional IRA to a Roth IRA.” Other experts agree. If you will earn reduced income in 2010 due to the recession and you have cash reserves with which to pay the income tax upon conversion, this could be a particularly advantageous time to convert.
Once converted, you need to leave the money in the Roth IRA for a minimum of five years, and meet the minimum withdrawal age of 59½, in order to withdraw the money without penalty.
You can even change your mind and undo the conversion if you meet certain deadlines. This might become a factor if the stock market falls significantly after a conversion. The latest date you can recharacterize the conversion is Oct. 15, 2011 if you file for an extension for the 2010 tax year. Some experts propose converting early in the year, to allow market gains to grow tax-free. If they are wrong about the direction of the market and we experience a double-dip recession with falling equity markets, then the shoe is on the other foot. The fact is, no one really knows which way the market will go in 2010, given the hefty and probably premature run-up in 2009.
Doing the Math
You are paying taxes on the total amount to be converted, based on your income tax rate. The amount you originally invested and your subsequent investment returns are immaterial, the current balance is what counts. So, if you want to convert $25,000 in pre-tax contributions and earnings and your tax rate is 25%, you are looking at a tax bill of $6,250.
The $25,000 will be added to your adjusted gross income; that could push you into the next tax bracket. That 25% tax bracket covers a whole lot of taxpayers. It runs from a married filing jointly adjusted gross income of $68,001 to $137,300. So, it is easy to see how you could add $25,000 to your income if it is below $110,000 and still not creep up into the next bracket. But the minute you hit $137,301, the tax rate is 28%. Of course, you can always back off a bit on the amounts to stay safely within the bracket you currently occupy. You can also maintain your existing tax bracket by spreading out the tax burden between 2011 and 2012.
Making the math more complicated is the fact that some IRA accounts include pre-tax and after-tax contributions. You have to figure out which are which if that is the case. You can exclude the value of after-tax amounts from taxes. Confused yet? That’s why we have a whole industry of tax advisors to ease your mind and lighten your wallet.
“See Your Financial Advisor for Details”
“See your tax advisor for details,” is what they, the media money people, all say—as a blanket “don’t blame me” disclaimer. The only trouble is, middle class people for the most part don’t have tax advisors. Or, if yours is H&R Block, forget it; the person who gives you dodgy advice will be gone before any adverse consequences arise. An Enrolled Agent, a specialized tax preparer licensed by the IRS, could give you good tax advice, but not that many people use one. A full-service CPA is just for the wealthy, and an investment advisor or Certified Financial Planner would have a theoretical conflict of interest if he or she stands to earn a commission if you reinvest through the Roth. A fee-only CFP would be impartial but may not know your tax consequences, and would still charge you $150 for the session.
Even if you do receive financial counseling on this issue there are too many variables in the calculation to arrive at a definitive conclusion about how much you will benefit in 10 or 20 years. You can test out some of these assumptions yourself on the IRA calculator at CalcXML.com. If you are young, and headed for a higher tax bracket in the future, most experts agree this could be a smart move. You can never know what tax bracket you will end up in, but one bet I would make is that tax rates, regardless of the bracket, will be higher in the future. For people who are closer to retirement, or who have difficult to figure future income prospects…what the heck, talk to your financial advisor.