Hot Topic: The New 2010 Roth Conversion Privilege

Starting January 1, 2010 an interesting new tax twist will allow anyone, regardless of their annual income, to be able to convert traditional IRA's into Roth IRA's.

To understand why anyone would consider converting a traditional IRA to a ROTH IRA, we must first understand how a traditional IRA works and how it usually comes into existence.

How You Acquired Your Traditional IRA

There are essentially two ways one acquires a traditional IRA:

  • The first way is to actively find a custodial institution (such as a bank or broker-dealer) and just open one
    • Typically the representative of the institution will make a sales pitch to you on what to buy within your IRA (a mix of cash, stocks, bonds, and other securities investments).
  • The second way is to acquire one by means of a retirement plan rollover, such as your 401(k)
    • Many times, when leaving your company, it is extremely disadvantageous to continue to leave your 401(k) money with your old employer (See FAQ's on why you should rollover).
    • The IRS permits a "rollover" of this money to an IRA account you again set up with your own custodian institution, namely a bank or broker-dealer.

The traditional IRA allows money invested in the plan to grow tax-deferred. However, when you are ready to withdraw this money at age 59.5 (or later), you will withdraw this money at your ordinary income tax rate and pay ordinary income taxes on the money. In other words, you will be paying yourself a salary just like your employer did all these years.

Traditional IRA Taxation

Despite advanced warnings, most people will wake up completely unaware of precisely how much of their IRA money will be subject to income tax. The short answer:

ALL OF IT!

That's right, every penny of money withdrawn from your IRA at retirement is subject to your then-going income tax rate. What do you think will be your tax bracket at that time? Truthfully, the answer to that question really depends on your personal situation. You can click on the link for a table of tax brackets as they have progressed over time.

But, just for arguments sake, lets say you will be in the 28% tax bracket. On a $100,000 IRA, you can expect to pay approximately $22,375.00 in income taxes on this money.

1 possible solution to this problem is to be holding a ROTH IRA at the time of your first withdrawal. All monies distributed from a ROTH IRA are distributed income tax free. In the past, people have not been able to take advantage of this strategy because of certain income requirements. In 2010 all of those income limitations will be repealed and anyone desiring to make a ROTH IRA conversion will be allowed to do so.

So what are the pros and cons?

The biggest and most obvious advantage to converting your traditional IRA to a Roth IRA is that you will not have to worry about tax brackets at all during your retirement years. All of the money from your ROTH will be distributed to you tax free and will continue to grow tax free as well.

This kind of seems like a no-brainer, especially for those of you who have enough money to pay the income tax on the conversion right now.

That is until you start really thinking about this...

What if the tax laws were to change in the future? Currently, the federal deficit is accelerating at a near unsustainable rate. At some point, tax revenues will need to be raised to offset deficit spending and to reduce the national debt to a more sustainable level.

Obligations to both Medicare and Social Security seriously threaten the governments ability to maintain its promises of an income tax free retirement, originally made by the Franklin D. Roosevelt back in 1938 when the idea of the Social Security Act was first conceived. Where will the tax revenue to pay for these programs come from?

Well, if a lot of upper middle class and wealthy people convert to a ROTH IRA, the government might starting see ROTH IRA's as juicy sirloins served up on a proverbial taxation platter.

No financial planner can really see into the future (you need only examine the craziness on CNBC on a daily basis to know that experts rarely see up from down), and if you find one who claims to, run the other direction. Just know this, ROTH Conversions are a viable strategy for those anticipate a high tax bracket in their retirement years and who have the cash on hand to make the conversion.

Make a careful inspection of your personal situation, consult your financial professional and get him or her to crunch some hard numbers for you, and get armed with the facts, before you make a move.

 

 

Tax PlanningEddie Patel