Monday, June 15, 2009

Minimize Your Tax Bill

When considering converting your traditional IRA into a Roth IRA the first question you should ask is: Do you anticipate being in a lower, higher or the same tax bracket during retirement? If retirement withdrawals or other sources of income will keep you in the same or push you into a higher tax bracket, why not pay taxes on your retirement account now so you can enjoy the benefits of a lower tax rate? This is exactly what a Roth conversion allows you to do. Here are three more tax reasons to consider:

1. Tax rates are incredibly low by historical standards (the highest tax rate, which has been as high as 92% in the past, is currently 35%). Most experts anticipate tax rates to increase in the near future in order for the government to fund liabilities such as Medicare, Medicaid, social security, and the presidential administration's economic stimulus package. If an investor expects to remain in the same or a higher tax bracket upon retiring, it makes sense to convert traditional IRAs to Roth IRAs now, pay taxes at lower anticipated rates and enjoy tax-free growth going forward.

2. After the recent market decline, investors will only need to pay taxes on today's deflated values, which would be significantly more cost-efficient than paying taxes on 2007 investment values. Would you rather pay taxes on a highly appreciated asset, or an asset with a greatly reduced value? Converting after asset values have dropped 40% will minimize the tax bill.

3. Taxes have already been paid on Roth assets, so the government does not require minimum required distributions (RMDs) from these accounts after the investor reaches age 70.5. This enables the money to continue to grow tax deferred for as long as possible. Additionally, at death, Roth assets pass to heirs tax free, whereas traditional IRAs will be accompanied by a tax liability.

Other Factors
Keep in mind that in 2009, only individuals with a modified adjusted gross income (MAGI) of less than $100,000 can convert an IRA to a Roth IRA. However, this income limit will be waived in 2010. Additionally, investors who convert in 2010 will have the option of splitting the tax bill from the conversion between 2011 and 2012 (however, we don't know what tax rates will look like during these years, so this may or may not turn out to be a good deal). When converting, ALWAYS pay the tax liability from another source of income in order to keep as much money growing tax-free as possible. Lastly, be conscious of IRA conversion distributions lifting you into a higher tax bracket. An investor can partially convert an IRA during multiple years in order to avoid having a large infusion of income in a single year. Of course, you should speak with a financial planner to ensure this strategy is right for your situation.

What if you had the unfortunate timing of converting your IRA to a Roth IRA in early 2008, and now you have to pay taxes on the high value of your assets when you sold them as opposed to paying taxes only on their low current value? What if you are concerned about converting now only to see the value of your investment drop in the coming months? Check back later this week to learn a strategy that offers protection from these possibilities.

No comments: