Your retirement portfolio hasn’t fully recovered from the recent bear market, the economy is weak and your taxes will soon be going up. So what can you do about it?
Convert.
Starting next year, anyone will be able to convert traditional IRAs, including SEP-IRAs and SIMPLE-IRAs, to Roth IRAs. Currently, conversions are allowed only for individual taxpayers or couples filing jointly with less than $100,000 a year in taxable income.
Those who convert either a portion of their assets or all of them should be aware that converted assets will be taxable as income during the year in which the conversion takes place. Assets on which taxes have already been paid – i.e., IRA contributions above the allowable limit for deductions – will not be subject to taxation when converted.
Financial professionals typically recommend deferring tax payments as long as possible, so why would anyone want to do something that would increase their taxes, possibly even putting them into a higher tax bracket?
In many cases, paying taxes now will cost far less than paying taxes later. Once taxes are paid on Roth assets, those assets can grow tax-free, as long as the assets are held in the Roth IRA for at least five years and the owner is 59½ or older before taking any distributions. Under current laws, assets can even be passed on to heirs without being subject to income taxes.
Advantages of Converting in 2010
While you may consider converting to Roth IRAs over a period of years, the quicker you convert, the more you may benefit, for several reasons:
- If you convert in 2010, resulting income taxes can be spread over two years. This is a one-time opportunity. For years after 2010, taxes will be due during the year in which the conversion is completed.
- If your portfolio gains in value, the base on which taxes are due will be higher if you wait to convert. If your assets increase in value, you will have to pay taxes on any gains when you convert.
- Convert in 2010 and you will be able to pay taxes at today’s lower rates. Tax cuts approved by Congress in 2001 are scheduled to expire in 2011, resulting in an automatic tax increase. Someone paying taxes at a 25 percent rate today, will be paying at a rate of 28 percent; the 28 percent rate will increase to 31 percent, the 33 percent rate will increase to 36 percent and the 35 percent rate will revert to 39.6 percent.
In addition, many believe tax rates will rise further to pay for new government programs, such as the economic stimulus package and possibly healthcare reform.
- The younger you are when you convert to Roth IRAs, the longer the timeline during which those assets can grow tax free. In fact, conversion to Roth IRAs may not be worthwhile if you are retired or close to retirement.
- The rules may change. Because Congress will be looking for new sources of revenue, Roth IRAs could become a less attractive means of reducing taxes.
Other Considerations
If you are unable to convert in 2010 because you cannot afford to pay taxes on the assets converted or because it would put you into a higher tax bracket, there are still plenty of reasons to convert at least some traditional IRA assets to a Roth IRA in the future.
Converting a portion of assets to Roth IRAs can reduce post-retirement taxes by putting the owner in a lower tax bracket. The taxpayer can, for example, take distributions from the traditional IRA up to the point where income would put the taxpayer into a higher bracket. Then additional funds, as needed, can be distributed from the Roth IRA tax free.
As when contributions are made outright to a Roth IRA, taxes paid are not included as part of the contribution. You will still be able to contribute new funds to a Roth IRA or traditional IRA up to the $5,000 limit ($6,000 for those 50 and older) during the year in which you make the conversion.
Before converting, be certain to consult with a tax advisor to determine the tax implications, as conversion may put you in a higher tax bracket.