Roth IRA Conversions - Taking Advantage of Historically Low Tax Rates
Using the Roth IRA Conversion to Take Advantage of Lower Tax Rates.
Now that the elections are over, you may be bracing for tax changes. Given the growing list of big bills that need to be paid: Medicare, the new Medicare prescription drug benefit, Social Security, billions in bridge and road repairs, billions more for mortgage-related financial bailouts, and the growing cost of supporting expensive wars in Iraq and Afghanistan, you don’t need to be a genius to realize that taxes are going to increase. Tax increases are going to impact everybody. The long-term capital gains rate (now 15%) could very well double. Some of the numerous loopholes currently available for income taxes will be closed indefinitely, so you won’t be able to hide for long. How do you legally evade possible higher tax rates? If you hold a tax-deferred IRA, this is the time to convert them (or at least start to consider converting) to Roth IRAs. We are currently in a period of historically low tax rates. I can almost guarantee higher tax rates in the near future and for a long time thereafter.
After converting a deductible IRA account, and if a taxpayer is under age 59 ½, the tax must be paid out of cash (not the IRA) or the taxpayer will suffer a 10% penalty. For example, you convert a traditional or tax-deferred IRA worth $100,000 in 2008. You may effectively have to pay around $25,000 in income taxes. This $25,000 must be paid out of your regular (taxable) accounts. If you were to pay the taxes using the conversion amount, and you’re under the age of 59 ½, you’d get hit with the 10% penalty, or $2,500 in this case. It just comes down to whether you can afford the taxes. Tax rates are not going down, so you will pay now or pay later if you’re in a traditional/deductible IRA. One other long-term consideration for converting involves the estate tax. Spending down an IRA before you and your spouse pass away can help beneficiaries possibly avoid an enormous tax burden. If the assets are already in a Roth IRA, withdrawing the entire amount much later in life will still be a tax-free withdrawal, and is a more easily accepted action emotionally speaking.
Under current tax law, taxpayers with adjusted gross income of less than $100,000 can convert a tax-deferred IRA and pay federal taxes at their ordinary income-tax rate. Starting in 2010, the $100,000 income limitation is lifted. Plus, there is an added benefit. Taxpayers making Roth conversions in 2010 can spread the tax bite over two years, paying half in 2011 and half in 2012. The downside is that tax rates are likely to be higher by 2010.
Nevertheless, Roth conversions take advantage of lower tax rates which is the major benefit. The main attraction of a Roth is that the investor pays no federal tax when the money is withdrawn upon retirement. A client aged 60 in the 35% tax bracket has a break-even point of about 15 years on a Roth conversion, earning 3% compounded annually (at 5%, the break-even is even less--nine years). In other words, it will take at least that much time to make back the tax paid. If your tax rate remains the same, over the time it makes sense to make the conversion. If your tax rates increase, which they’re likely to do, it’s almost a no-brainer.
A word of caution: you should always ask your financial or tax advisor before engaging in any transaction regarding your IRA or any other tax deferred vehicle…especially one in which assets are removed or withdrawn from the account. If you would like us to help with your current situation, including assistance with rollovers, please call us!
