What to Do About Your IRA
If you have money in an Individual Retirement Account, or an IRA rollover account, you’ll be faced with a big financial decision next year. Should you convert your current IRA, on which you’ll pay taxes when you withdraw the money, into a tax-free Roth IRA? Conversions have always been available to people with income under $100,000. But in 2010 and beyond, there will be no income limit for conversions from traditional to Roth IRAs. Anyone with an IRA, or an IRA rollover account that might have resulted from leaving a previous employer’s 401(k) plan, will be eligible to convert all, or part, of the IRA to a Roth IRA.
Remember, withdrawals from a traditional IRA are taxable as ordinary income at the time you take the money. But, since all withdrawals from a Roth IRA, whether contributions or investment gains, are taken out tax free, this conversion proposition is very attractive at first glance. But there’s one big catch: You have to pay income taxes now on the amount you convert to the Roth. Before calculating a Roth conversion, consider your answers to two basic questions:
No. 1: Do you think personal income tax rates will be higher or lower over the next 10, 15, 20 years? Most people would guess that tax rates, even on retirees with lower income, will be higher in the future. The government spending binge has to be paid for, and it will take more than just increased taxes on “rich” people.
No. 2: Do you think the government will keep its promise to allow tax-free withdrawals from Roth IRAs over the next 10, 15, 20 years? Tax laws have been changed before — in the name of “fairness.” Just ask seniors who counted on receiving tax-free income from municipal bonds how they feel about having that income added back to their “modified adjusted gross income” to determine how much of their Social Security check is subject to taxes! Or, ask seniors with higher incomes how they feel about paying twice the Medicare premiums — even though high earners paid more in Medicare taxes over the years.
So do you really think that if you convert to a Roth IRA now, the government will keep its promise to let you withdraw your money completely tax free in the future? If you’re willing to trade paying taxes today for future tax-free promises, here are the issues you’ll have to consider. (The most detailed presentation of these trade-offs can be found online at www.schwab.com/Roth.)
When to pay the taxes. If you do the conversion from a traditional IRA to a Roth IRA in 2010, you have a choice of recognizing all that income in the same year (2010) — or split equally between the next two tax years (2011 and 2012). Either way, it’s going to be a huge tax bite. Remember, your traditional IRA or IRA rollover accounts are filled with pre-tax contributions along with untaxed gains over the years. When you do the conversion, you’ll add all that previously untaxed “income” to your current income to determine your tax liability.
Where to get the tax money. Don’t plan to use money from the IRA to pay the taxes. If you do, you’ll lose the main reason for doing the conversion: future tax-free growth of all that IRA money. And if you’re under age 59-and-a-half and take IRA money to pay the taxes, you’ll face that 10 percent penalty. That means the conversion is most advantageous if you pay the tax bill with savings you’ve built up outside your IRA account. But how will you feel about writing that huge check to the government next year? What better things might you have done with that money you’re sending to the government to pay the conversion tax?
The one group that might benefit most from this conversion opportunity are younger savers. They’ll have more time for the money to compound and overcome the taxes paid now. Then all that money would come out tax free at retirement. And for those who have lots of money, there is an additional benefit to converting to a Roth. Not only are there no required minimum withdrawals from a Roth (at age 70-and-a-half), but if you don’t spend the money in your lifetime, your heirs can allow it to continue to grow tax free, or withdraw it tax free — unlike withdrawals by benefi-ciaries of a traditional IRA. Plus, by paying taxes on the money now, at today’s relatively low rates, you lower the amount of your estate. That might be helpful if the estate tax returns at much higher rates.