given where most expect tax rates to go, paying it off in 2010 may be a better option.
Cincinnati, OH (PRWEB) December 1, 2009 -
Why would someone volunteer to pay income tax next year by converting a traditional IRA to a Roth IRA? By not converting, there will be no current tax on assets, regardless of their investment performance, which sounds like a no brainer. But, according to Chip Workman, Lead Advisor with Cincinnati-based The Asset Advisory Group, this unprecedented time may warrant this approach. "The promise of a future tax payoff, combined with prevailing economic conditions and recent tax law changes makes converting to a Roth IRA in 2010 a possibility worth at least investigating for many investors," Workman says.
With a traditional IRA, contributions may be tax deductible, but the amount deducted and subsequent earnings will be fully taxed as income when withdrawn during retirement. (The same rules apply to IRAs holding assets rolled over from traditional 401(k) or other employer-sponsored plans.) Generally, investors must begin taking those taxable distributions during the year after the year in which they reach age 70½.
In contrast, contributions to a Roth IRA are never deductible, but qualified distributions from a Roth that has been established for at least five years are completely tax free. And because the government won't benefit when distributions are taken, it doesn't require them.
Until now, the catch has been that high-income individuals can't contribute to a Roth IRA, and converting a traditional IRA to a Roth hasn't been allowed for those whose adjusted gross income exceeds $100,000. The latter rule changes in 2010, when the income cap for conversions is eliminated. In addition, though a conversion to a Roth requires an investor to pay income tax on the amount converted, if the conversion takes place in 2010, the tax payment can be spread over 2011 and 2012. "Spreading the tax payment out may or may not make sense, depending on your situation," advises Workman, "given where most expect tax rates to go, paying it off in 2010 may be a better option."
Choosing between saving for retirement with a traditional IRA or a Roth is in part a question of whether it's better to pay the IRS sooner or later. Being taxed on current contributions to a Roth IRA or for a conversion from a traditional IRA takes money away now, but could result in a better outcome later, either through enjoyment of tax-free distributions or passing along the proceeds to heirs, whose withdrawals also won't be taxed. The law permitting anyone to convert to a Roth, coupled with depressed asset values from the recent market downturn, adds interesting twists to this debate.
Consider these five reasons it may pay to convert.
1. It costs less to convert an IRA whose value has plummeted. "As painful as the recent downturn has been for investors, the ability to convert to a Roth IRA using depressed assets is a silver lining in otherwise tough times," Workman explains. Taxes will be due on the value of the account at the time of the conversion, regardless of what it may have been worth a few years earlier. Suppose the assets in an IRA were worth $500,000 a year ago, but in 2010, they are worth only $400,000. At the top current income tax rate of 35%, that's a savings of $35,000.
2. Avoid a higher tax bill later if rates rise. With individual tax rates at near-record lows and tax revenue falling far short of federal budget commitments, tax rates are likely to go up in the near future. It may be better to take an immediate tax hit under current tax law, even if all or part of a conversion is taxed at the top rate of 35%, than to risk losing much more to the IRS later.
3. Converting to a Roth IRA provides maximum flexibility on distributions. There's not much give in the rules on withdrawals from traditional IRAs and 401(k) plans. "Once you reach age 70 ½, the government requires that you take minimum annual distributions to draw down your account," says Workman, "failing to meet the required distribution means a 50% penalty on any shortfall." With a Roth, an investor is able to take as large or small a distribution as they choose each year, allowing for the option of leaving the account intact to provide tax-free income to heirs.
4. A partial conversion to a Roth offers the ability to customize tax liability and benefits. "This does not need to be an all or nothing game," says Workman. A conversion can consist of as much or as little of an investors' IRA assets as desired (although, for now, the option of stretching out tax payments applies only to conversions in 2010). Making a partial conversion allows for some diversification of tax strategy, limiting current payments to the IRS while also providing some tax-free income during retirement.
5. Do not make these decisions alone. "While conversion sounds like a great tax alternative, this is certainly not right for every or even most investors," Workman cautions, "these decisions need to be made with an independent financial advisor and CPA in the room." Thoughtful analysis from these professionals will lead to the best possible outcome in light of this potentially fleeting opportunity.
About Chip Workman, CFP® and The Asset Advisory Group
Chip Workman, CFP®, Lead Advisor with The Asset Advisory Group in Cincinnati, Ohio, has spent his career serving the financial needs of his clients. Workman earned his MBA from Xavier University and undergraduate studies were completed at Miami University in Oxford, OH. He spent the early part of his career in various private banking and trust roles, including establishing a private banking presence for several community banks in Cincinnati. He is also a member of the Financial Planning Association, the nation's largest organization of professionals dedicated to championing the financial planning process. The Asset Advisory Group offers independent, fee-only financial planning and investment management services aimed at providing individuals and families with financial and emotional security.
Workman, along with the other advisors at The Asset Advisory Group, have contributed to WNKU's Business Beat, Cincinnati Business Courier, and the Cincinnati Enquirer as well as other financial trade and consumer publications.
Visit http://www.taaginc.com for more information about Mr. Workman and the rest of The Asset Advisory Group's team of advisors and staff.
When you need a knowledgeable, professional to speak on complicated financial topics in an easy-to-understand and lively way, please call Chip Workman and the advisors of The Asset Advisory Group.
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