To Roth IRA or Not?
When you hear about building a Roth for your retirement in 2010, rest assured that nobody wants you to follow the former lead singer of Van Halen into obscurity. It’s time to understand what a Roth IRA can do for you.
Simply put, a Roth is a retirement account that can provide tax free withdrawals under certain conditions. When you pull money out, no tax is due on the money you originally invested, and most importantly- if you follow all the rules- no tax is due on any income and growth over the years, explains Lynn Ballou of Ballou Plum Wealth Advisors.
The catch is that you can only deposit after-tax investments to a Roth and generally can’t tap the fund without penalty until you are 59 ½ years old. You also have to wait five years before withdrawing anything. For this reason, tax law used to restrict Roth eligibility to people with six-figure incomes. But the election-happy budget hawks in Congress have reworked the tax code so that anyone, at any income level, can convert a traditional IRA to a Roth.
Here’s what you need to know.
Ballou warns you to calculate the total tax effect of a conversion: “You have to pay taxes on every dollar you convert. And to make it a logical move, you need to use after tax dollars to pay that tax.” That can mean up to a 40 percent tax on every dollar that shifts from traditional to Roth coverage. However, for conversions in 2010, you can spread to pay taxes in 2011 and 2012.
You should also think about your total exposure to taxes, especially if you think you may need the cash in the next year or two. “Income tax rates are scheduled to go up after 2010 and it is possible that they’ll go even higher than currently scheduled. Therefore, waiting to pay the tax may cost an individual more than simply paying the tax in 2010,” points out Richard Willinger, principal in Mercadien, P.C.
The crux is about whether you or the government has to wait for a reward, says retirement specialist Michael Kresh. if you use the IRA money to pay the taxes now, and investment returns stay in the middle single digits, it will take nearly 20 years for your net after-tax value to exceed the value of deferring your withdrawals until you retire at age 60 or older. “So Uncle Sam gets his money now on a $500,000 IRA – a windfall of $100,000. But it will take almost 20 years of returns for the IRA owner to have more net money after taxes,” says Kresh.
Still, most people, especially if they expect to work for a long while, can find ample reasons to convert. Here are a few.
If tax rates increase, keeping your assets in a traditional IRA may mean higher taxes on future distributions, says Darrell Canby, president of Canby Financial Advisors. And if your portfolio has not fully recovered from the bear market, you can save on taxes because the government will calculate your bill from the (depleted) value of your IRA at the time of conversion. And you’re going to have to take the money eventually: while traditional IRAs oblige you to take out a minimum at age 70 1/2, Roth IRA don’t. And- tada!- that means Roths can keep growing after you retire, outpunching taxes. “Withdrawals do not count as income, a benefit when calculating taxes on Social Security benefits,” adds Mark Snyder of Mark Snyder Financial Services.
And your kids can benefit from a conversion. If you leave them a traditional IRA, they will be responsible for income taxes as they make distributions. If they inherit a Roth IRA, there will be no income taxes.
Still unsure? You can simply convert whatever part of your IRA feels affordable from a tax perspective, says Ballou.
If you convert and change your mind, you can do undo it. Says Ballou, “As long as you change your mind by the deadline, for most folks that will be October 15, 2011, then no harm done.”
More than you can say for deciding to quit the band and let Sammy Hagar take your place.
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