ROTH Conversion

Everyone is talking about it . . . What should YOU do about it?

Here’s what you need to know!

SINCE THEIR CREATION IN 1998, ROTH IRAS have been a valuable tool for those who want to save for tax-free retirement income. The Roth has many advantages over the Traditional IRA, besides tax-free withdrawals.* For example, there are no required minimum distributions (RMD) on Roth IRAs, and the contributions can be withdrawn from the account at anytime without tax or penalty.*

ROTHHowever, many investors have been unable to utilize this tool due to certain income limit restrictions which have been in place since the Roth was created. Effective January 1, 2010, the rules are changing, and now all investors will have access to the Roth IRA through a conversion of their Traditional IRA or Qualified Retirement Plan (401k, 403b, etc).

*Restrictions, penalties, and taxes may apply. Unless certain criteria is met, Roth IRA owners must be 59 1/2 or older and have held the IRA for 5 years before tax-free withdrawals are permitted.

The Roth Conversion Rules:
The amount converted to a Roth IRA will be included as ordinary income for the year in which the account was converted. However, for 2010 only, the taxpayers can elect to defer half of their tax liability to 2011 and the other half to 2012.

The Case for Converting
Tax Free Income: Let’s assume you invest $1,000 in an IRA, and after 20 years it has grown to $10,000. We will also assume that you are in the 20% tax bracket now, as well as 20 years from now. In a Traditional IRA, you will receive a tax deduction of $200 on your contribution amount of $1,000, but will pay $2,000 in taxes upon withdrawing the $10,000. In a Roth IRA, you receive no tax deduction on your contribution, but you also pay no tax on the withdrawal. By using the Roth IRA, the entire growth portion of your investment is totally tax-free.

Hedge against increasing tax rates: For decades, the United States had top marginal tax rates as high as 50%, 70%, and 90%. As a matter of fact, for the past 50 years, there have been only five years (1988 to 1992) when the top marginal tax rate was less than the current 35% rate. Considering the current budget deficits and the costs of the bailouts and stimulus, many believe that income tax rate increases are inevitable. If you share that belief, then you may wish to realize taxable income now and take advantage of today’s historically low income tax rates. However, if you think you will be in a lower income tax bracket, the taxes you pay today could potentially be higher than the taxes you would pay when you are ready to make withdrawals.

Current market provides a low-cost conversion opportunity. Considering many individuals have experienced a loss in their retirement accounts over the last 18 months, now may be a perfect time to recognize the income tax liability. An IRA worth $100,000 in 2007 may now be worth $60,000. By converting the $60,000 to a Roth, the taxpayer is potentially locking in the tax liability at the lower amount. Should the $60,000 eventually recover its losses and grow back to $100,000, the taxpayer can avoid paying taxes on the $40,000 difference. The amount you convert will be taxed as ordinary income, so it is important to consider whether you will be in a higher tax bracket as a result. If so, you can choose a partial conversion or conduct multiple conversions over multiple years.

Tax Diversification: Other than tax-exempt municipal bonds**, very few investments grow tax-exempt. By having tax-free investments in addition to your taxable investments, you are able to better control your taxable income, and potentially keep yourself in a lower tax bracket. For example, let’s say a married couple needs $100,000 of annual income in retirement. For 2009, a married couple filing jointly with the personal exemption and taking the standard deduction, can have up to $86,600 of earnings and still be in the 15% tax bracket. If the couple had a Roth IRA, they could take the additional $13,400 they need from the Roth, giving them the $100,000 income they need and still be in the 15% bracket. By building a tax-free Roth account, retirees will have more flexibility and control in managing their taxes.

Avoid the RMD: In the above example, if one of the spouses is over age 701/2 and has a traditional IRA, they are required to take a taxable distribution each year. The amount they are required to withdraw is set by a government table, based on age. To illustrate, an individual, age 71, with a traditional IRA balance of $500,000 must withdraw approximately $18,800. If their income need is only $13,400, they are taking more money, and paying more taxes than they need. With a Roth IRA, there is no RMD. You take only what you want to, and pay no taxes on the distribution.

Estate Planning: Not only does the absence of the RMD rule help to preserve the account balance for those who wish to leave their IRA to heirs, using the Roth IRA provides a way for them to leave a legacy totally free of any income tax.

Roth Conversion Considerations:
These key factors should be considered when converting retirement assets to a Roth:

  • Investment Timeline
  • Whether you have assets outside the IRA to pay the resulting income tax
  • Current tax bracket
  • Anticipated tax bracket in retirement
  • Whether you believe tax rates will be lower or higher in the future

The retirement planning professionals at Paducah Financial Consultants can take you through an individual assessment and help you determine if a Roth IRA Conversion is right for you. Call George, Wendy, or Keith for more information or to set up your personal consultation. IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a Conversion from a Traditional IRA to a Roth IRA, or a Re-Characterization of a Roth IRA to a Traditional IRA. Prior to using such a strategy, please see your Financial and/or Tax Advisor.

**Municipal bonds are federally tax-free, but may be subject to the AMT (alternative minimum tax)
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