Blue Light Special

Now May be the Time to Convert Your Traditional IRA to a Roth IRA

Every cloud has a silver lining. In today’s down market, the perfect storm of low investment account values and historically low federal income tax rates may make this an ideal time to convert your Traditional IRA to a Roth IRA. As background, when you convert a deductible Traditional IRA to a Roth IRA, you must pay income taxes on the account balance. (If you have made nondeductible contributions to a Traditional IRA, you would pay taxes only on the earnings on those contributions if you convert to a Roth.)  However, once those taxes are paid, all qualified withdrawals from your new Roth IRA are tax-free, provided you hold your Roth IRA for at least five years and are at least 59 ½ years of age when you access the funds.

While the diversification benefits of adding a tax-free Roth to your portfolio are clear, in past years the cash outlay to pay conversion taxes may have proved too great a hurdle to clear. However, it’s likely your Traditional IRA has declined in value over the past year, meaning you will owe less in taxes now than you might have in the past. What’s more, as federal income tax rates are as low as they’ve been since the 1930s, your conversion to a Roth could buy out Uncle Sam at a bargain basement price. The extra bonus is that your new Roth will capture gains from the market’s eventual rebound on a tax-free basis.  Ka-ching.

Let’s say several years ago when you left a job, you rolled your 401(k) account into a Traditional IRA invested in equity funds. Appreciating the diversity a Roth IRA could provide, you considered converting the $800,000 balance on January 2008 into a Roth. However, the additional $800,000 of ordinary income (which, by the way, would not have counted towards determining if you were over the $100,000 Modified Adjusted Gross Income (MAGI) Roth conversion limit) with your marginal tax rate of 35%, would have meant paying an extra $280,000 in income tax.

However, today, that $800,000 account is worth just $500,000. That means, at the same 35% rate, converting to a Roth would result in a $175,000 tax bill. Of course, you grumble, I’m paying less in taxes because my account is worth less. That’s true, and while it’s always attractive to put off paying taxes to a future date, once your Roth account is five years old and you are age 59 ½, you can withdraw your principal and earnings tax free. If, in those five years, stock funds rally and the value of your new Roth IRA is once again $800,000, everything, including $300,000 of growth, is yours tax free.

Obviously, the greater the tax-free growth, the higher future income tax rates go, and the longer you remain in the top income tax bracket, the more beneficial converting to a Roth would be. However, what if the market declines significantly in the months after your conversion, making your move less appealing? The great thing about the Roth IRA conversion is that you can change your mind. Let’s say that you convert your $500,000 Traditional IRA and pay $175,000 in taxes. If the market declines further, you might wish you had the money you paid in taxes back. Amazingly, you have until October 15th of the year following your conversion to do a Roth “re-characterization” and change your account back to a Traditional IRA.

More Good News

And there’s more good news. While today your MAGI, individual or joint, must be under $100,000 to convert a Traditional IRA to a Roth IRA, that $100,000 income cap is scheduled to disappear in 2010, courtesy of the Tax Increase Prevention and Reconciliation Act of 2006.  Then you can convert your Traditional IRA to a Roth IRA regardless of your income or filing status. In another seemingly too good to be true twist, if you convert a Traditional IRA to a Roth IRA in 2010, you can spread your ensuing tax bill over 2011 and 2012.

If you plan to take advantage of lifted income restrictions, it may make sense to begin setting money aside now to pay those inevitable taxes. Remember, you won’t want to withdraw money from other IRAs or your 401(k) account to pay the income taxes for your conversion because you’ll be assessed the 10 percent penalty if you are under age 59½.

If you’re considering a Roth conversion, please contact us for additional information and guidance. We’d be happy to review the benefits of diversifying your next egg between taxable and nontaxable accounts and other potential advantages of a Roth IRA. For example, while Traditional IRAs require distribution to begin at age 70½, you are not required to take distributions from your Roth during your lifetime. Accordingly, the Roth doubles as an estate planning tool, where you heirs potentially could benefit from decades more of tax-free growth.

Finally, if the current balance of your Traditional IRA is large enough to generate a prohibitive tax bill, we will help you calculate the tax impact of completing just a partial conversion. If you’re interested in this conversion opportunity, please give me a call.

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