Unless you’ve been a cave for the last three months, you have no doubt heard of the unique opportunity to save that our Government has given us for this year only. Everyone, regardless of their income can now convert a traditional IRA or pension plan to a Roth IRA. Moreover, while there is still tax to be incurred (the amount of the conversion hits the first page of your 1040 as income earned), you have the option to defer the tax entirely in your 2010 tax year and to spread it equally over the tax years 2011 and 2012. In other words, Roths are on sale for 2010 — buy now, pay later. But it gets even better, because you can change your mind until October 2011, if you decide conversion is not for you, and reconvert (“recharacterize”) to your IRA or plan without tax or penalty.
Now that you know what the Roth conversion opportunity is all about, for this and the next few posts, I am going to discuss some of the many considerations, rules, and strategies to consider to determine if conversion is right for you.
Let’s start with the basics and point out who is:
Most likely to benefit most from converting:
• A young person, whose retirement is decades away, and who can afford to pay tax now in order to enjoy an easy retirement later. $10 a week or $40 a month with tax-free compounding at 8% for 30 years would yield $140,000 in retirement savings. If you were to save $200 per month you’d end up with $1,050,000.
• Someone who has a chance to hit a homerun on an investment, like someone forming a new business. Hockey-stick investments accomplished tax-free and then compounded for life can result in phenomenal amounts. I know of someone investing as little as $1,800 in their own startup through a Roth IRA who in a little over ten years as grown that to several hundreds of millions all tax-free, and they are still 20 years from normal retirement!
• Someone, who has no need for near-term liquidity or withdrawal from their retirement savings, and whose current retirement investments are substantially devalued as a result of the recent recession, but are expected to recover in the future. For example, people owning real estate in their IRA who have experienced devaluation due to the market conditions can convert at these lower values, paying less tax, and then allow them to recover tax-free in their Roth IRAs.
• People who believe that tax rates will increase substantially in the future and that the combination of their tax bracket and tax rates will place a larger burden on them in the future than their tax impact from converting, are persons to consider converting.
• Those who want to leave their retirement savings to their heirs. Once funds are converted to a Roth IRA, they will grow tax-free during your lifetime and yours heirs at your death (if named as your beneficiaries and your custodian handles stretch or inherited IRAs). Your heirs will also pay lower estate taxes (which go back into effect in 2011), because the Roth funds have already been taxed.
Less likely to benefit from converting:
• Someone who has to use funds from their IRAs to pay the tax for the amount converted. You will be effectively paying tax on some of your money taxed, as the money used for paying the tax will be taxable when withdrawn to pay the tax on the remaining amount that is converted.
• Those who intend to leave their IRA to a charity. They will be incurring a tax from conversion that could be avoided if they left the money in their traditional IRA and then donated the money tax-free to the charity.
• Those who think tax rates will decline or that their tax bracket will be much lower when they withdraw funds from their IRA at retirement.
Some other factors to take into consideration when deciding to convert or Not convert to a Roth IRA. Click here