Wednesday, October 28, 2009

Convert or Not Convert? THAT is the question...

So what about that Roth conversion that everyone is talking about? We LOVE the Roth IRA! Why? Because since you are contributing to the plan with the “after tax” money, you don’t have to pay taxes on accumulated gains when the funds are withdrawn at retirement (and over the years, it certainly adds up). We will leave the growth chart analysis to our colleagues, financial planners. Take our word for it, the numbers work. Historically, income limitations prevented many individuals from opening such an account. In addition, income limitations have been imposed on anyone wanting to convert a regular IRA into a Roth.

Here come the great news… Starting in 2010, income limitation on conversions to a Roth will be lifted. That doesn’t mean that the income limitation on new contributions are lifted, but it does seem like there is a way around that one as well. We are thinking that if your income is too high to qualify to make a new Roth IRA contribution, just make a regular IRA contribution and convert (seems like a loophole, but nevertheless will work…)

So, if you make the election to convert your regular IRA into a Roth IRA, you will have to pay all taxes due on conversion. Well, you can’t have it all. Remember, that converting in 2010, doesn’t mean paying tax in 2010. You will be presented with an option to pay the taxes owed on the conversion over 2 years 2011-2012. The current legislation is going toward increasing the tax rates in 2011, and probably even more so in 2012; it might make sense to satisfy the debt in 2011.

Why is this so important now? Think about the conversion value. You have contributed $50,000 to an IRA, the value of which has declined to $25,000. Sounds familiar? It certainly does in this market. Well, if you convert that IRA into a Roth, you will only pay tax on the $25,000 at conversion, and all future earnings growth will be tax free. Of course it would be a bit painful to convert at $25,000, pay tax at the conversion and have the value drop to $12,000. Regardless, assuming a somewhat steady growth of even 3% per year, it makes all the sense to convert. In addition, if you leave the Roth IRA to your kids, and the money continues to grow, they will enjoy tax free distributions; and the accumulated savings from taxes on the accumulated growth over the years will be of a significant magnitude. Sounds worthy of taking a chance…

So while we always advocate tax deferrals (a dollar of tax paid tomorrow is certainly better than today), this seems to be a valid exception. There are of course many unforeseen circumstances which can possible make this conversion a mistake… Who knows, the taxes might be abolished on capital gains ten years from now, the values might decline even further, etc…

There is no doubt that this conversion should be on everyone’s radar. As always, we are here to help!

1 comment:

  1. Makes sense. Not expecting 50k to go down to 25k soon again, but it can happen in the future. In any event, paying taxes now and then enjoying tax free growth makes sense in the current market environment.