Ordinarily, when you have an important financial decision to make, you need a lot of time to consider all the factors and make an informed decision. But with one particularly valuable opportunity, there's no reason to wait -- and every incentive to act now, with nothing to lose.
Jumping on the Roth bandwagon
As we've highlighted this week, the benefits of Roth IRAs are now available to any investor who has a retirement account. Thanks to the lifting of income restrictions on conversions between traditional and Roth IRAs, many who had been denied access under previous laws can now take advantage of provisions that others have used for years.
Converting to a Roth can bring you a number of benefits. But those benefits come at a price: You have to include every penny you convert as taxable income, which will likely cost you a substantial amount in increased taxes. As a result, you may be reluctant to make a quick decision so early in the year, before you know what the rest of your tax picture will look like.
However, there's one incredibly useful facet of Roth conversions that most people don't focus on. It's potentially the most valuable thing about a Roth, and it amounts to a money-back guarantee.
Get a do-over
It sounds like a TV commercial: "If for any reason you're not satisfied, you can undo your Roth conversion absolutely free, with no further obligation." Yet that's exactly what the tax laws allow investors to do. With what's called a recharacterization, you can undo your Roth conversion in three easy steps:
- Tell the financial institution that's acting as the trustee of your Roth IRA that you want to recharacterize the conversion, and get it to prepare the necessary documentation for the IRS.
- Calculate the amount you'll need to return to your traditional IRA. That includes not only the original amount you converted, but also any earnings on the converted money.
- Work with your financial institution to return that amount to your traditional IRA account.
As it turns out, that opens up a wealth of potential money-saving opportunities. And best of all, if you convert now, you have until Oct. 15, 2011 to give the IRS your final answer.
Don't wait and see
With the recharacterization in your arsenal, you can act now without any fear about the consequences. If things don't go the way you want, you can always recharacterize and make things exactly like they would've been if you had never converted.
Moreover, the earlier you act, the better off you'll often be. Consider that over time, stocks have risen more than they've fallen. All other things being equal, converting earlier means that the dollar amount of your conversion will be lower, thereby costing you less in taxes.
Say your IRA had 100 shares each of these four stocks in 2009:
|
Stock |
Value of 100 shares on Jan. 2 |
Value of 100 shares on Dec. 31 |
|---|---|---|
|
Coca-Cola |
$4,590 |
$5,700 |
|
Sears Holdings |
$4,149 |
$8,345 |
|
DuPont |
$2,618 |
$3,367 |
|
IBM |
$8,737 |
$13,090 |
Source: Yahoo! Finance.
If you converted right away when the year began, the total amount converted would be just more than $20,000. Yet if you did what many people would naturally do, and waited until the end of the year to think about your taxes, the value of your IRA would have risen to more than $30,000 -- and you'd have a tax bill that was 50% larger.
Conversely, though, say you had invested in losing stocks like Apollo Group
Get going
With a free do-over in your pocket, there's one more reason why you shouldn't wait to do a Roth conversion. But converting isn't an all-or-nothing proposition. How much of your traditional IRA should you convert to a Roth right now? We'll address that question tomorrow.
Stay tuned the rest of this week as Dan looks into the benefits of the new Roth conversion. Up next: deciding the right amount to convert.
