Now that 2010 has arrived, many individuals will have a possible ‘once-in-a-lifetime? tax decision to make. Should you convert your ‘tax-deferred? traditional IRA assets and transfer them into a ‘tax-free? Roth IRA?
A tax-deferred IRA means that you will eventually owe income taxes on the amounts you withdraw from a traditional IRA.
The income tax liability is delayed until you withdraw funds because you got a tax deduction when you deposited into your traditional IRA or rolled funds over from a tax-deferred retirement plan like a 401 (k), 403(b) or 457 plan.
A tax-free Roth IRA allows for (hopefully) growth without having to pay income taxes on the earnings withdrawn. While tax-free always sounds better, Roth IRA deposits are ‘after-tax? which mean you receive no current tax deduction. Many taxpayers want the immediate satisfaction of a reduction in their pending tax bill even if it means having to eventual pay income taxes on their IRA gains.
If you have a traditional tax-deferred IRA and want to convert some or all of the funds to a tax-free Roth IRA, you normally have to pay income taxes on the amount you convert in the tax year you make the change. Plus individuals whose joint income exceeded $100,000 are normally denied the opportunity to move funds from a traditional IRA to a Roth IRA.
Two major changes take place in 2010: 1) Any income taxes owed on the conversion can be split between 2011 and 2012, and 2) There is no income limit on who can convert.
The ‘income-splitting? rule allows a taxpayer to convert a regular IRA to a Roth IRA in 2010 but opt to include one-half of the taxable income in 2011 and the other half in 2012.
While this is attractive to people who like to delay paying the IRS as long as possible, what happens if your tax bracket is higher in 2011 and/or 2012?
Concerning income limits, if you have always wanted a Roth IRA but the IRS deemed you too successful to have tax-free growth, your opportunity has arrived ? but only for one year.
Before you send your Congressperson a thank you card for this opportunity, realize that this is designed to give the government a one-shot tax boost when people convert funds and thereby incur the income tax liability over two years rather than over the life of their withdrawals.
During the next several months, taxpayers will be flooded with offers to convert their traditional IRA’s to Roth IRA’s from many financial professionals and salespersons who could say or write: ‘Act now or you will NEVER get this chance again!?
Questions you should ask yourself if you are seriously considering if a Roth IRA should be in your future:
1) Will your FUTURE tax bracket likely be high enough to take advantage of tax-free income? If you have a guaranteed pension plus adequate savings, the answer might be yes. With no pension, little savings and primarily Social Security to live on, you might be in a lower tax bracket so that very little of your tax-deferred withdrawals are reduced by income taxes. In that case, keep the traditional IRA.
2) Are you planning on leaving the majority of your IRA’s to your heirs when you die? Regardless of your tax bracket, can you afford to withdraw minimal amounts of your IRA’s in order to maximize what you transfer to your heirs? In that case, Roth IRA’s are a far more effective asset transfer device than traditional IRA’s. The tax-free potential growth of a Roth IRA can provide substantial benefits to your heirs. Are your heirs likely to be working and in higher tax brackets when they inherit your IRA’s? If yes, then receiving Roth IRA’s could be substantially better for them tax-wise since they would still be obligated to pay the deferred tax liability from inherited traditional IRA’s.
3) Will you need to make IRA withdrawals and when? Do you have long-term care nursing insurance or could you possibly need to tap into your IRA’s for that possible expense? Are you confident that your healthcare costs will be adequately covered in retirement?
Yes, 2010 provides a great opportunity for SOME individuals who might benefit from converting from a traditional IRA to a Roth IRA. But beware of sales hype and the lure of ‘tax-free? gains. Run the numbers to make sure you benefit tax-wise from a conversion. But more importantly, analyze your GOALS and potential financial circumstances. You have all of 2010 to make a decision. Take your time. Do your homework and enjoy the opportunity to make a decision.
Henry S. Woloson is an attorney and counselor at law in Independence Township. Call 248-625-6736.