Disciplined Investing: Is it time to convert your IRA to a Roth?
Mar 3, 2010
ROTH IRAs
Roth Individual Retirement Accounts (Roth IRAs) are one of the most tax-efficient vehicles for retirement planning. Similar to traditional IRAs, Roth IRAs permit tax-free investment growth. However, after meeting asset holding period requirements, tax-free withdrawals may be made from a Roth IRA any time after age 59 ½ at the account holder’s discretion.
Historically, higher income households have only been able to participate in traditional IRA plans, whose mandatory distributions after age 70 ½ are taxed at ordinary income rates. However, new federal tax rules which take effect in 2010 will permit traditional IRAs to be converted into Roth IRAs, regardless of personal income levels.
NEW CONVERSION RULES
The new rules contain a large amount of conversion flexibility. Partial conversions are permitted, i.e., any portion of a traditional IRA may be converted into a Roth account. Any IRA balance (or balances) may be converted in stages over at least two years. If you have several traditional IRAs, you can convert some accounts and leave others alone. Lastly, if you decide to rescind a Roth conversion, you may “re-characterize” the converted account back to traditional IRA status before October 15 of the year following the conversion.
The distribution from the traditional IRA that takes place upon conversion will be partially taxable and partially tax exempt for two reasons. Firstly, to the extent that the traditional IRA’s current value exceeds the contributions made, the gain will be treated as taxable income. Secondly, non-tax deductible contributions in the IRA will not be taxed on conversion. Additionally, should you decide to convert this year, you have two tax reporting options: 1) Report the entire amount on your 2010 return or 2) Report half the converted amount on both a 2011 and a 2012 tax return.
For 2010, individuals and married couples with modified adjusted gross income exceeding $120,000 and $176,000, respectively, are not eligible to make direct contributions to Roth accounts. However, as long as Congress does not subsequently repeal the new conversion feature, higher-income investors can fund Roth IRAs by establishing a traditional IRA and subsequently converting the assets into a Roth account at a later date.
A POTENTIAL STRATEGY
Consider dividing a large-balance traditional IRA into several smaller traditional IRAs. Convert the smaller accounts into separate Roth IRAs, each following a different investment strategy. If one of the new Roth accounts declines in value, you may reverse the conversion while leaving the better-performing accounts alone. By “recharacterizing” the converted Roth as a traditional IRA, you negate the conversion tax liability for the depreciated account. Going forward, you may reconvert the account to a Roth at a lower tax basis. (The moratorium for 2010 conversions is October 15, 2011).
KEY POINTS TO CONSIDER
• Is the value of your traditional IRA still lower than before the 2008 stock market decline?
Investments with high appreciation potential (or whose values are currently depressed) probably warrant conversion. Converting today at lower values means less current tax liability (as well as no future tax liability on the appreciation).
• Do you have sufficient funds outside the IRA to cover the tax liability created by the conversion?
Paying the tax with cash withdrawn from the converting IRA will lower the amount of tax-free income that can accumulate in the Roth account. If possible, conversion taxes should be paid with “outside money.”
• Do you expect to pay higher federal income tax rates in future years?
While the Roth conversion will result in a tax payment in the conversion year, the assets will appreciate without any future tax liability. Conversely, distributions from traditional IRAs will be taxed at your marginal federal rate at the time of withdrawal. Tax rates (particularly for higher-income earners) may eventually rise to fund large federal budget deficits which are projected over the next decade.
• Do you plan on waiting past age 70 ½ before commencing IRA withdrawals?
Mandatory distributions after age 70 ½ constrain the appreciation potential of traditional IRAs. Alternatively, Roth accounts permit tax-free compounding to continue indefinitely. Because there are no required distributions, a Roth IRA allows more flexibility in managing your investments and cash flow.
• Do you intend to leave IRA proceeds to heirs?
Roth IRAs can act like a life insurance policy. Not only are Roth distributions non-taxable to the account holder, they are also non-taxable to heirs. As a result, a Roth IRA can play a significant role in your estate planning – a role sometimes occupied by life insurance.
Please contact Kent Fisher, CFA or Andrew Blass at PRI Investments to discuss whether a Roth conversion in 2010 makes sense for you.
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