Often, you hear writers telling you that you should stop waiting and do something right now. With this piece of advice, though, waiting until next year before you act might be the best move you could possibly make.
On Jan. 1, millions of investors will get an opportunity that many have never had before -- the ability to convert some of their retirement funds into a Roth IRA. Many planners have looked forward to this prospective tax-law change for years, but with the new year just months away, it's beginning to look like some investors may actually get a chance to take advantage of Roth IRAs for the first time.
The change and what it means
Since their introduction in 1998, Roth IRAs have essentially been off-limits to many high-income taxpayers. Single taxpayers having an adjusted income of more than $120,000 and couples earning $176,000 or more in 2009 aren't allowed to make regular contributions to Roth IRAs, and those with adjusted incomes of more than $100,000 aren't eligible to convert existing traditional IRAs into Roths.
But in 2006, the income limit for Roth conversions was abolished for the 2010 tax year and beyond. Of course, at the time, it was highly uncertain whether tax provisions passed under the former administration would survive a change in leadership. Yet although there has been ample time for the new administration and Congress to make tax-law changes, some believe that due to the financial crisis, tax increases are likely off the table until at least 2011. That means that the Roth provisions will likely be allowed to take effect.
Typically, when you convert to a Roth, you have to pay income tax on the amount converted. In 2010, however, the provision allows you to defer that tax, including half of it in your 2011 income and the other half in 2012. That may help keep those who convert from jumping up into a higher tax bracket.
Should you convert?
The big question, of course, is whether it makes sense to convert. Ordinarily, you want to avoid paying tax as long as possible. But many planners point to the fact that doing a Roth conversion essentially allows you to lock in today's tax rates, rather than having to pay tax later on as you withdraw money from your traditional IRAs. If you believe rates will rise, then paying low rates early could be profitable in the long run.
In addition, beaten-down portfolio values actually benefit those who are thinking about converting. For instance, say you own in your IRA 1,000 shares of each of the seven worst Dow performers over the past two years:
|
Stock |
Value, Sept. 4, 2007 |
Value, Sept. 4, 2009 |
Tax if Converted in 2007 |
Tax if Converted Now |
|---|---|---|---|---|
|
Alcoa (NYSE:AA) |
$36,410 |
$12,180 |
$12,744 |
$4,263 |
|
American Express (NYSE:AXP) |
$60,770 |
$32,840 |
$21,270 |
$11,494 |
|
Bank of America (NYSE:BAC) |
$51,080 |
$17,090 |
$17,878 |
$5,982 |
|
Boeing (NYSE:BA) |
$95,920 |
$49,150 |
$33,572 |
$17,203 |
|
General Electric (NYSE:GE) |
$39,040 |
$13,870 |
$13,664 |
$4,855 |
|
Caterpillar (NYSE:CAT) |
$76,850 |
$46,110 |
$26,898 |
$16,139 |
|
Cisco Systems (NASDAQ:CSCO) |
$32,320 |
$21,840 |
$11,312 |
$7,644 |
Source: Yahoo! Finance. Tax assumes 35% bracket on IRA conversions.
If you converted your entire account now, you'd pay less than $70,000 in taxes, instead of almost $140,000 that you would have paid two years ago. If stock prices stay low into 2010, paying tax on those low values now might save you a bundle down the road.
But there are also some very good reasons why you might not want to convert:
- Lower income in retirement. Many people -- especially the high-income earners who've been locked out of Roth IRAs until now -- see their taxable income fall in retirement. Often, that translates into lower tax rates on traditional IRA withdrawals during retirement than you'd pay if you converted next year.
- Retroactive Roth taxes. Some fear that the government may change its mind and find a way to tax Roth IRAs in the future. In that case, those who convert would end up unnecessarily paying tax twice.
- A big tax bill. If you don't have the extra money outside your traditional IRA to pay the taxes you'd incur by converting, then you should probably steer clear. It's definitely not worth paying taxes and penalties to pay that bill from IRA funds.
The best of both worlds
In general, I'm a big fan of having some of your money in both Roth and traditional IRA or 401(k) accounts. That strategy helps you hedge your bets against whatever your future tax situation may be. So, if you've been completely locked out of Roth IRAs until now, you should definitely consider taking what may be a short-lived opportunity to convert some of your money.
