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With the ongoing health care debate dominating the news, many people are unaware of one tax law change that took effect on January 1, 2010, that could significantly impact many taxpayers for years to come.
Effective this year, any taxpayer may convert a Traditional Individual Retirement Account (IRA) to a Roth IRA. In previous years, this was restricted to those taxpayers with a modified adjusted gross income below $100,000. While this change may seem minor at first, serious consideration should be given to converting IRAs for several reasons. This article will explain the difference between a Traditional IRA and a Roth IRA and discuss the pros and cons of converting a Traditional IRA to a Roth IRA.
Created in 1974, Traditional IRAs provide taxpayers an immediate tax deduction for contributions made into the account. There are no income taxes paid on the account until funds are withdrawn. As long as withdrawals are 7) Priced right – this area has a tendency to get overpriced as overzealous “Wall Street marketers” hype stock prices to unreasonable levels Thankfully the market tsunami of early last year brought energy stocks down to reasonable levels and in some ways separated the common-sense winning strategies from those that were inflated on hype. We are pleased that we were able to buy such a quality portfolio of solid energy companies at great prices. Some of FIM Group’s client holdings include: Criteria Corp, Pargesa and Cheung Kong Holdings, which provide exposure to both traditional and alternative channels of energy. For example, Hong Kong-based Cheung Kong Holdings owns a large chunk of Hong Kong Electric, which built Hong Kong’s first commercial-scale wind farm – Lamma Winds. For more information on our wind and other alternative energy investments, visit www.fimg.net. There, you’ll find links to the World Wind Energy Association (www.wwindea.org) and the websites of the companies mentioned above. *Please Note - made after age 59½, they are taxed as ordinary income. Withdrawals can be delayed until age 70½, at which point annual required minimum distributions (RMD) must be taken.
In contrast, contributions to Roth IRAs, which were created in 1997, do not result in a current income tax deduction. However, as long as withdrawals are made after age 59½, no income taxes are due. In addition, Roth IRAs are not subject to the RMD requirements.
In general, there is no economic benefit of a Traditional vs. a Roth IRA for most individuals as long the following assumptions are made:
- Future income tax rates are the same as current income tax rates.
- Assumed earning rates are the same for all time periods.
- There is no estate tax liability due on the IRAs upon the death of the account owner.
For 2010, current tax law allows an individual to convert a Traditional IRA to a Roth IRA and elect to pay the income taxes currently or defer the tax liability by reporting one half of the amount converted in 2011 and one half in 2012. It is important to note that this is the taxpayer’s option, giving more flexibility and more income tax planning opportunities.
In most cases, it is not beneficial to pay the income taxes due on conversion from the IRA account itself.
For those individuals whose estate may be subject to estate taxes upon their death, the Roth conversion would result in a lower taxable estate, since the income taxes paid upon the conversion would reduce the total assets of the estate. In addition, married taxpayers may want to consider a Roth conversion as a way to reduce future income taxes for the surviving spouse. Since the surviving spouse will be required to pay taxes at higher single taxpayer rates, converting to a Roth IRA will not only eliminate future RMDs but would also result in any withdrawals being income tax-free.
In general, a Roth IRA is more “income tax-friendly” to a non-spouse beneficiary, since any withdrawals are not subject to income taxes.
One often overlooked aspect of Roth IRA conversions is the ability to “recharacterize” a converted IRA. This in effect allows you a “do over” if the value of the converted IRA suffers a significant drop in value from the date of conversion to the due date of the tax return including extensions (currently October 15 of the following year).
Recharacterizing a Roth IRA is an “all or nothing” option; one cannot pick and choose which investments within the account can be recharacterized. However, a taxpayer can create multiple Roth IRA accounts, giving one the option of only recharacterizing those accounts, if any, that drop in value.
So is a Roth IRA conversion right for you? This is not an easy question to answer. On one hand, you are in effect “pre-paying” income taxes. This has to be weighed against the benefits listed above and what income taxes will be in the future.
If you would like to explore the Roth IRA conversion further, please contact a FIM Group wealth management advisor who will be glad to evaluate your personal situation.
