INVESTMENTS Future tax rates affect IRA decisions
For many, the time is right to convert to a Roth IRA.
DALLAS MORNING NEWS
Everything else being equal, the decision to keep your money in a traditional Individual Retirement Account or a Roth IRA comes down to one question: Do you think your income tax rate will be higher now, when you're working, or later, when you're retired?
With the traditional IRA, you invest with pretax dollars, and you're taxed on the money only when you withdraw it in retirement. With the Roth, you invest with after-tax dollars and don't pay any taxes on withdrawals in retirement. Simply put, it's a question of when you pay the taxes.
On the fifth birthday of the Roth IRA, with a tax cut in effect and the possibility of higher rates in the future, some financial experts say now may be a good time to convert to a Roth.
"This is definitely a carrot out there do that," said Michael W. Busch, a certified financial planner and president of Vogel Financial Advisors LLC in Dallas. "Rates now are going to be as low as they're going to get. They may even go higher."
What's more, the slump in the stock market knocked down the value of traditional IRAs, so if you convert now, you would be paying tax on a smaller amount.
"It's a lot less painful to make that kind of conversion than it was a couple of years ago, so you have less of a gain and you have lower taxes," said Brian Mattes, spokesman at Vanguard Group, a major mutual fund firm.
But there are two caveats. First, conversions to Roth IRAs are limited to people with adjusted gross income of less than $100,000. Second, you need a chunk of change to pay the taxes. In order to convert a pretax, traditional IRA to an after-tax Roth IRA, you have to pay taxes on the value of the conversion.
(That's assuming all the contributions to your traditional IRA were deductible. If part of your contributions were nondeductible, that portion would not be taxed in a conversion because you've already paid tax on it.)
"The primary disadvantage of conversion is that you trigger an immediate tax bill," Busch said.
And that's "a big hit for most people," said Marcia Mantell, vice president of retirement products at Fidelity Investments, the giant mutual fund company.
"If you're going to do the conversion, the way you benefit the most is if you can afford to pay the tax bill from another source," she said, discussing a hypothetical person with $100,000 in a traditional IRA. "You want that full $100,000 to be working toward your retirement savings."
Theoretically, you could use part of the money you're converting to pay the tax, but that might be shooting yourself in the foot.
"If any of the IRA funds are used to pay the tax, those amounts could possibly be subject to both regular income and a penalty tax," said J. Richard Joyner, a partner at Ernst & amp; Young LLP in Dallas.
If you can handle the tax bite, many experts say, a conversion makes sense right now. But in today's economy, the tax issue kills the decision for many people.
That may be one reason why Fidelity hasn't seen many conversions to Roth IRAs.
"During the past IRA season (January through April 15 of this year), it was the first time since the Roth launched where we saw more new IRAs being opened in traditional IRAs than Roth IRAs," Mantell said. "It was 51 percent to 49 percent."
The shift surprised her. One reason may be that people need the tax deductions; they don't think they can afford to pay taxes now on their retirement savings, even if they think the tax will be higher later.
"I wonder what the true impact of the economy is on people, with the decision whether to deduct today or get the tax-free distribution tomorrow," Mantell said. "There are just too many more external considerations now with the economy being so tough. It's not as straightforward as it had been back in 1998, when things were going quite well in the market and people were gainfully employed."
The Roth IRA was created under the Taxpayer Relief Act of 1997 and became available in 1998.
You don't pay tax on Roth IRA withdrawals if you've had the account for at least five years and you're 591/2 years old or older. Other conditions apply.
With a traditional IRA, taxpayers are subject to a 10 percent early-withdrawal penalty, in addition to regular income tax, on amounts withdrawn before 591/2.
But the Roth has an advantage on withdrawal rules: With a traditional IRA, you're required to start making withdrawals at age 701/2, so Uncle Sam can start getting his cut. With a Roth, you can delay taking withdrawals until whenever you want.