Is it time for a break ? that is, a tax break? With the stock market down 25-40% from its fall 2007 highs, it’s certainly a time to consider converting your traditional IRA to a Roth IRA, especially if you’re not planning on retiring soon. You will pay a one-time tax on the conversion ? but with the market down, that tax will be less than you would have paid last year. As a result of the conversion, you will have more flexibility with your money when you are ready to use it.
The pros of a Roth conversion. A Roth IRA gives you two huge benefits: tax-free growth and tax-free income distributions in retirement (providing you are age 59? or older and have held your Roth IRA account for 5 or more years).1 Additionally, you can still contribute to a Roth IRA after age 70? – and you don’t have to take mandatory withdrawals from it.2 These facts alone might motivate you, especially if you are in your thirties or forties.
A Roth IRA conversion can also be useful for older investors who don’t need their IRA assets. If you don’t think you’ll need to tap your IRA, you might consider doing a Roth conversion and leaving the Roth IRA to your heirs. Untouched, the Roth IRA assets can keep compounding tax-free across the rest of your life (and subsequently, the rest of your surviving spouse’s life). Another advantage: converting that untapped traditional IRA to a Roth will reduce your taxable estate.3
All 2008 Roth IRA conversions, by the way, will have a 1/1/08 start date, so you get the full year credit toward the 5+ years you need to own the account before taking income distributions.4
The cons of a Roth conversion. On the downside, the conversion does trigger a tax, and you’ll need the money to pay it. You will pay tax on any earnings and pretax contributions in lieu of paying taxes upon subsequent withdrawals from the Roth IRA.
Don’t think about using your current IRA assets to pay the conversion tax ? if you’re younger than 59?, you’re looking at a 10% penalty on the amount you withdraw, and you’ll throw away the chance for tax-free Roth IRA compounding of those assets. (If the amount you want to convert might send you into a higher tax bracket, you could simply do a partial Roth IRA conversion.)
You also don’t want to do this if you think you’ll drop into a much lower tax bracket when you retire. For example, if you’re in the 25% federal tax bracket now and the numbers seem to indicate you’ll be moving into the 15% bracket after you retire, you’ll be paying income tax on the conversion at your current 25% rate. If you’re moving down only a handful of percentage points (from, say, the 28% bracket to the 25% bracket), then it’s a different story.
For the record, contributions to a Roth IRA aren’t tax-deductible.2
Do you qualify for a Roth conversion? You can make the conversion if your modified adjusted gross income (MAGI) is less than $100,000 in the year you convert the IRA. By the way, that includes income that would result from the conversion.1
The income limits determining eligibility for Roth IRA contributions are higher than $100,000 ? for 2008, eligibility is phased out between MAGI of $159,000 and $169,000 for joint filers and between $101,000 and $116,000 for singles.5
How about a recharacterization? Okay, if you’re a glass-half-empty type who thinks the market will go lower in coming quarters, you could opt to convert your traditional IRA to a Roth sometime in the remainder of 2008 and then reverse (or “re-characterize”) the decision prior to Oct. 15, 2009. If you recharacterize, you will get the taxes back that you paid on the Roth conversion.6
The deadline & timeline. You need to withdraw funds from your IRA before 2009 to make sure a conversion counts as a 2008 Roth conversion. After that, you have 60 days to make the rollover.4
Talk to your CPA or tax advisor before you make a move. Keep in mind that the tax code isn’t exactly set in stone right now, and who knows what will happen with parts of the tax code after 2010. So consult your CPA or tax advisor before arranging any rollover, trustee-to-trustee transfer, or same-trustee transfer of your IRA assets.
Loran S. Coffman is the founder of Wealth Preservation Strategies, LLC and may be reached on the web at www.WPSinvestments.com, by phone (248) 693-5599, or by email advisor@WPSinvestments.com. See ‘The Science of Financial Health?, Coffman’s exclusive weekly financial column on the web every Wednesday at www.LakeOrionReview.com.