Dave Carpenter, AP Personal Finance Writer
CHICAGO (AP) — Why pay taxes before you absolutely have to? Because you may pay significantly more if you wait.
The prospect of higher tax rates is prompting a new wave of interest in Roth IRA conversions by people who want to lock in current rates or take advantage of a significant one-time tax advantage that expires at year's end.
Financial services firms including Bank of America Merrill Lynch and Principal Financial Group, as well as financial planners, report an uptick of conversions and queries in recent weeks. After Election Day, Congress will resume the debate over possibly increasing federal taxes.
Roth Individual Retirement Accounts are widely touted as paying off for just about everyone in retirement. Converting a traditional IRA to a Roth enables you to benefit from tax-free growth in the account and you won't pay taxes on withdrawals in retirement.
The tax-free growth can be indefinite because you'll avoid the requirement of traditional IRAs and 401(k)s that owners take withdrawals from their accounts every year after age 70½, resulting in taxable income. And if you end up not dipping into it at all, it will be a tax-free inheritance for your heirs.
But what if you're nearing retirement and unsure whether the possibility of a slightly higher tax rate after your working years makes it worth taking the tax hit now? That can be a tougher call, perhaps worth consulting a financial adviser about.
"Anyone with a significant balance in an IRA should at least evaluate a Roth conversion before the year ends," says Ed Slott, a Rockville Centre, N.Y., accountant and publisher of the IRA Advisor Newsletter.
A surge of Roth conversions took place earlier this year, because households with more than $100,000 income were newly eligible. Here are reasons why it's important to take one more look at the Roth-or-no-Roth decision soon, and points to consider when you do.
PAY TAXES AT CURRENT RATES.
Converting no later than Dec. 31 will enable you to lock in today's tax rates, which could be rising as soon as 2011 as both federal and state governments seek to address huge deficits. After a lull since tax season, there's been an increase in Roth calls and queries to financial firms. Merrill Lynch says it did as many conversions in August as in all of 2009.
The tax advantage of converting now doesn't mean everyone should do it. It probably doesn't make sense if you are a retiree drawing on an IRA to meet living needs, or if you think you will be tapping it in the next five years or so. It also may not be advisable if it pushes you into a higher tax bracket. This may happen because any portion of your traditional IRA that hasn't already been taxed will become taxable income from the conversion.
If you are confident you will be in a lower tax bracket at retirement, there's also no rush to convert. But don't take that for granted. Not only are rates likely to rise, but you could have substantial taxable income from Social Security, pension and investments.
Dave Carpenter, AP Personal Finance Writer
Regardless what happens with tax policy changes, the one for-sure deadline on Roths is that 2010 is the only opportunity to delay your tax payments on the conversion and spread them over two years. Make the switch now and you can either claim the income from the conversion on your 2010 tax return due next April or split it between your 2011 and 2012 returns. Spreading out the tax burden also may help you avoid a one-time bump to a higher bracket because of the conversion.
MAKE PARTIAL CONVERSIONS.
If you're hesitant to convert because of all the uncertainty about future tax rates, it doesn't have to be all or nothing. Having a combination of some tax-deferred and some taxable accounts will give you more flexibility with future withdrawals, says Maria Bruno, an investment analyst for Vanguard.
It also may be the best way to minimize the tax hit in any given year. That tax strategy has been evident in the significant number of partial conversions in recent weeks, according to Chuck Toth, director of product management for Merrill Lynch. "That means people really are thinking it through," he says.
SELL STOCKS TO PAY TAXES.
The downside to converting now is you have to pay the tax bill. And most financial advisers will tell you not to pay the tax out of the converted funds because you'll lose the benefit of tax-free growth on that amount. If you're under 59½, you will pay a 10 percent penalty.
One good source of money may be selling individual stocks. Many investors hang onto stocks because they don't want to pay the 15 percent capital gains tax. But Slott says the likelihood of a coming boost to that rate makes it doubly sensible as a way to pay for the conversion. "You'll never see a rate as low as 15 percent again in your lifetime, I don't think," he says. The top capital gains tax rate is currently set to revert back to 20 percent next year.
INVEST MORE AGGRESSIVELY.
Once you convert, you can use the Roth to make your riskiest investments since you won't pay capital gains taxes. You can make the Roth the last retirement account you tap, giving those emerging markets funds or small growth stocks decades to roll up some gains.
"It gives you the chance to grow your account aggressively for maybe the next 30 years," says Christine Fahlund, senior financial planner for T. Rowe Price. "You can afford to take some chances in there."
Speaking of risk, many people are hesitant to convert to Roths out of fear the government will someday go back on its word and overturn Roths' tax-free status.
That's typically one of the first questions Slott gets from skeptical investors, and he points out factors that make it very unlikely. Not least of those is that those who convert to Roths pay taxes now instead of later.
"It would be political suicide if they didn't keep their promise," he says. "And they're not going to throw the golden goose out so fast, because it's a money maker for the government."
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