With the economy in the doldrums, smart investors can still give their retirement portfolios a boost by staying on top of the tax laws. The IRS is allowing savers a one-time perk if they convert a pre-tax IRA to a Roth IRA or a traditional 401(k) to a Roth 401(k) by the end of this year. Instead of paying tax on the entire converted amount as part of your 2010 return, you can split the taxable income and report half when you file for 2011 and half when you file for 2012. (In the future, the entire converted amount will be taxable in the year of the transfer.)
Those who expect to be taxed at a higher rate in retirement than they are now have the most to gain by converting their nest egg. With a Roth, you pay income tax on your deposits, but withdrawals made after age 59½ from accounts at least 5 years old are tax free. In contrast, traditional IRAs are not taxed until you withdraw your money (or convert it). This can be costly if your income rises later. If you think that might happen, then converting will allow you to "lock in today's rates," notes Richard Kopcke, a research economist at Boston College's Center for Retirement Research.
Running numbers. Consider hypothetical 55-year-old Sallie Stuart, who is in the 28 percent tax bracket. Stuart has a $5,000 traditional IRA earning 7 percent interest annually. In 10 years this IRA will be worth $8,360 after taxes if her tax rate has fallen to 15 percent. But if her tax rate increases to 35 percent, perhaps because she takes on lucrative consulting jobs or inherits money, it will be worth just $6,393 after taxes, according to calculations by the Center for Retirement Research. If Stuart chooses to convert her IRA to a Roth this year and pay her taxes up front, then the portfolio will be worth $7,082 in 2020, regardless of her tax bracket then. (The traditional IRA will have that same value if her tax rate remains 28 percent.)
Roths also offer another advantage: flexibility. Traditional IRA holders must take minimum distributions (paying income tax as applicable) annually after age 70½. People with Roths do not. It's "perfect for estate planning," says financial adviser and IRA expert Ed Slott of Rockville Centre, N.Y. Your beneficiaries can receive tax-free distributions of the money. And Roth holders who live "until age 90 will have 20 more years of compounding to pass on to their children or grandchildren tax free," Slott says.
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Keep in mind that while you can take out any amount from your IRA, all of the withdrawal should be converted to a Roth if you are under 59½. Otherwise, the IRS will assess a 10 percent early-withdrawal penalty on any portion that you do not roll over. Experts recommend that younger investors have the cash on hand outside their retirement accounts to cover the anticipated tax so they can avoid the penalty. "If you have to pay the tax from the IRA you are going to convert," says Kevin Brosious, a certified financial planner and president of Wealth Management Inc. in Allentown, Pa., then "it usually doesn't make sense" to make the change.
For the first time, the IRS will now also allow people making over $100,000 to convert traditional IRAs to Roths. While these higher-income investors are not permitted to open new Roths, or to make further contributions to the converted account, they still have another option: They can contribute each year to a nondeductible IRA and convert the funds to a Roth, says Shelley Ferro, a certified financial planner with Ferro Financial in Metairie, La.
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Remember, though, that a large conversion may temporarily put you in a higher tax bracket, raise your Medicare premiums, and even affect your child's eligibility for college financial aid. If so, then you may well opt to roll over a smaller part of your IRA balance now. You can always convert more in a future year. And should you change your mind about your 2010 conversion, the IRS allows you until Oct. 17, 2011, to move your money back to a traditional IRA and file an amended return.