This might be the time for you to rethink Roth IRAs. The financial meltdown – pretty much a once-in-a-lifetime event – created what will probably be a once-in-a-lifetime opportunity. Converting a traditional IRA to a Roth could make economic sense for many portfolios.
There are three main reasons for considering this now.
Paying taxes now at relatively low tax rates could prove much less painful than paying at higher rates later. (We have to begin paying the cost of averting global financial meltdown sometime).
If you’re not familiar with Roth IRAs, the most important differences from regular IRAs are:
- Money put into a Roth IRA is not tax deductible. In return, any money coming out of a Roth IRA is not taxable – as long as specific conditions are met. This non-taxed status applies to both the money you put into the Roth and all the money it earns. (Nor will it count in determining taxation of social security benefits.)
- To qualify for the tax-free treatment, you cannot take money out of the account until the later of five years from establishing the Roth or age 59½.
Like traditional IRAs, you are limited in 2009 to annual contributions of $5,000 ($6,000 if you’re over 50 years old). Also, owners of traditional IRA’s are required to start drawing money out at age 70 ½, but Roth IRA owners do not have to take these “required minimum distributions.” Thus they have more flexibility in withdrawing funds on an “as needed” basis.
But I mentioned conversions to a Roth. That’s where you might save some bucks.
A conversion is essentially what it sounds like; convert a regular IRA into a Roth IRA. If this is such a good deal, why doesn’t everyone convert? There are two reasons:
- You must pay the taxes due on your regular IRA when you convert it, so it costs you money right up front.
- An income limitation keeps many people from converting IRAs into Roths. If you have a modified adjusted gross income (MAGI) above $100,000, you are not permitted to convert an IRA to a Roth IRA. (The good news about this second constraint is that the income limitation has been abolished. Starting in 2010 you will be eligible to convert to a Roth IRA regardless of your income level.)
Paying the taxes due is an obstacle for many people. Because compounding is crucial to growing your assets, generally it is mathematically worthwhile to convert to a Roth only if you pay those taxes from some other source. If you were to pay the taxes from your traditional IRA, your Roth will begin with less money than was in your regular IRA. Furthermore, the money held back from an IRA conversion to pay the taxes may be subject to a 10% early withdrawal penalty if you are under age 59 ½.
Let’s suppose the taxes aren’t a problem. Why make this conversion now? Because the terrible economy and stock market from which we are now (hopefully) recovering probably decreased the value of your account significantly below what it was a couple of years ago. You’re hoping that your assets go up in value after you convert so that you pay a lower tax now instead of higher tax later.
What if you are wrong? Suppose the economy and the market tank again and the value goes down further? Here’s the surprising aspect of Roth conversions. You have until you pay your taxes for the year in which you convert to get a “do over.” Suppose you converted in January and then the account value dropped even lower during the year. The IRS gives you until your 2010 taxes are due to change your mind.
By a process called “recharacterization” you can undo your conversion. Recharacterization makes it as if it never happened. And as long as you wait at least 60 days, you can do it all over again and pay taxes on the new lower value. It’s not often the government gives you a break like that one!
Also special in 2010 (and only in 2010), if you convert to a Roth, you can pay the taxes due over two years; that is, half with your 2010 taxes in 2011 and half with your 2011 taxes in 2012.
Closing thoughts:
If you don’t have a traditional IRA but do have some other kind of “qualified” retirement plan, you might still be able to take advantage of this. Depending on your specific plan, you may be eligible to roll your “qualified” funds to an IRA. You can then convert them to a Roth IRA.
If you don’t have enough money to pay the taxes for converting your entire IRA, partial conversions are also permitted. You can convert a part of your IRA for which you can afford the taxes. And you can do that over and over again if things change and you can afford to pay the taxes later.
I’ve emphasized before that I am a financial advisor, not an accountant or an attorney. So I ran this idea past one of Asheville’s premier CPAs, David Worley, to get his thoughts on the subject. Worley said “I’ve already met with several individuals to plan traditional IRA to Roth IRA conversions for 2009, as well as in 2010 when the rules are greatly liberalized. Through planning we structure the conversion at minimum current tax costs, and we also discuss the ability to leave Roth accounts to children and grandchildren, greatly enhancing the tax free accumulations that are possible in the Roth account.”
If your advisor hasn’t discussed the potential in this with you for your specific situation, you might want to bring it up to him or her … or find another advisor. As I said at the start, this could be a once-in-a-lifetime opportunity.
Note, though, not everything is for everyone. As they say on TV, don’t try this at home. Everyone’s specific situation is exactly that – specific. Get professional advice about whether or not this makes sense in your circumstances.
The views and opinions expressed are those of the Jamison Financial Group based on market and economic conditions as of December 8, 2009 and are subject to change. Nothing in the above is meant to be, nor should it be construed as, investment advice or recommendations to buy or sell any security. Past performance is no guarantee of future results.