The battered market and possible tax hikes may make this the right time to switch over your retirement fund
Your retirement portfolio has lost half its value. Perhaps your family income is down, too. Want a little good news?
If you've got enough cash in the bank, this may be a great time to convert your traditional individual retirement account to a Roth IRA, which offers some significant tax advantages.
"I think this is the best time ever," says Ed Slott, a Rockville Centre, N.Y., accountant nationally known for his expertise on retirement plan issues. Three key factors are currently combining to make conversion attractive, he says: A battered stock market, today's lower family incomes, and the likelihood of higher tax rates in the future.
Why convert? Both types of retirement accounts allow money to grow tax free. When it's time to make withdrawals, money taken from traditional individual retirement accounts, which are generally funded with pretax dollars, is taxed as regular income. But withdrawals from Roths, which are funded with after-tax dollars, are free of both income tax and minimum distribution requirements.
That can translate into surprisingly large tax savings over the life of a retirement account. Financial adviser Beth Gamel of Pillar Financial Advisors in Waltham, for example, recently ran the numbers for one retiree with a $322,000 IRA and a life expectancy stretching 27 years into the future. Converting to a Roth would produce an immediate $129,000 tax bill, but Gamel's projections showed that the retiree would save nearly three times that amount by simply not having to pay any additional taxes on those funds during her lifetime.
"We were shocked," Gamel says, noting that she hadn't expected conversion to be such an attractive option. The big gamble, she says, is whether the retiree will live long enough to enjoy all that tax savings. But should she die sooner than expected, the tax benefits would pass to her heirs, who then would be able to take their distributions income tax free.
But conversions aren't for everyone. For one thing, there are income limits. To be eligible to convert in 2009, you need to have a modified adjusted gross income of no more than $100,000, either for an individual or a married couple filing jointly. Those who don't meet the income requirements will have to wait until 2010. At that time, the income cap will disappear entirely, allowing anyone who wants to convert to do so.
A Roth conversion also comes with a price tag. You will need to pay income taxes on every dollar moved from a traditional IRA to a Roth. Given current stock market prices, the tax bill triggered by a conversion today will likely be just a fraction of what it would have been this time last year. Still, people need to come up with the cash to pay the bill, and that will eliminate many who are having a tough time making ends meet.
While some may be tempted to pay that tax bill with money from their retirement plans, financial advisers say that's often a bad idea. Not only will it reduce the amount that actually ends up in the Roth for long-term tax-free growth, but you may also end up paying penalties if you're not yet 59 1/2 years old, says fee-only financial planner Michael Broad of Newton.
Many people, however, are sitting on large cash accounts after moving money out of the battered financial markets, Broad says. Others may have come into large inheritances. In either case, using that money to pay the conversion taxes now "could turn out to be a great deal," he says.
If the conversion tax bill looks too steep, remember that you don't have to convert everything all at once. You may decide to only convert a portion of your IRA to a Roth, leaving any decision on the rest to future years. Slott suggests that children consider paying the tax bill for their parents' Roth conversion. That would allow them to inherit retirement plans that have income-tax-free distributions and can be stretched over their lifetimes.
Such planning may sound risky in the middle of a recession. But Slott points out that Roth conversions come with a built-in escape clause. Convert now and if you decide it was a bad idea, you have until Oct. 15, 2010, to change it back through a recharacterization, whether you have filed for a tax extension or not.
"It's like getting to bet on the horse after the race is over," he says, noting that someone can recharacterize for any reason, whether it be further declines in the stock market or simply making too much money to qualify under the income cap.
The bottom line: If tax rates rise, as many expect, the taxes paid by converting now could look like a bargain. Add to that the appreciation of today's beaten down assets moved to a Roth, and the strategy is even more appealing.
"The only caveat," says Slott. "Don't go broke converting. Your first concern is being able to pay the rent."