Roth Around the Clock

I remain a big fan of the Roth conversion – that is converting a traditional IRA into a Roth.  Still it’s worth noting that if you converted to a Roth in 2010, the time to change your mind about that move ends on October 17^th of this year.  The reason to convert in the first place is a belief that you’ll pay less tax on the money in the IRA if you pay taxes now rather than when you are forced to take minimum distributions of that money.  (IRAs defer taxes, but they don’t prevent them.)  If anything has happened since 2010 to change that belief, now is the time to act.    

When you convert an IRA you have to pay the taxes Uncle Sam didn’t collect when you first salted that money away.  In 2010 our Uncle was feeling generous, so he provided the option to pay those taxes over two years.  Also, there are income restrictions that stop some people from contributing to a Roth (For 2011, Adjusted Gross Income of $179,000 if married filing jointly, $122,000 for singles and $107,000 for married filing separately).  A rollover though, is open to everyone.  So if you think the Roth version of tax deferral is good for you, but can’t qualify for regular contributions, conversion is a back door that remains perpetually open.   

The problem is the time lag between the conversion and the tax payment.  Let’s say when you cashed out of the IRA in 2010 the value of your account was higher than it is now.  If you stay put, you’ll pay taxes on money you may never get to spend.  Given the recent market volatility this is not just an academic argument.  The other area of risk is the protracted recession has put financial pressure on people who might not have expected to be short on funds when tax bills come due in 2012.  For those folks the idea of paying the taxes early may still look good, but may be impractical.

 You are allowed to undo or “recharacterize” the conversion.  You can put the funds back in an IRA.  If you made the move in 2010 though, the clock is ticking.  The Wall Street Journal article on this topic says Vanguard Group had a 423% increase in conversions in 2010 and Fidelity reported similar results.  If you recharacterize, the money goes back into a traditional IRA.  You can change your mind a second time, but you can’t reconvert in the same year you “unconverted” (I’m not sure that’s actually a word, but presumably context communicates the meaning).  If you’ve already filed your 2010 return, you’ll have to amend that as well as deal with the 2011 paperwork. 

The Journal article goes on to say that the conversion levels in 2011 were way down, and the number of recharacterizations hasn’t spiked despite the reasons to think they might.  The thought is that people who had the wherewithal to pay all those taxes in 2010 are generally still doing well enough to handle the commitment.  Also, the same market volatility that can cause one to recharacterize can raise the value of the account when you’re required to take minimum distributions and increase your tax bill yet again.  If you’re interested, there are more details about this on my most visited website (sad but true) http://www.irs.gov, look for Publication 590. 

One other “gentle reminder” in terms of dates…  October 15^th is drop dead for filing individual 2010 taxes.  No exceptions. 

Fall Tax Planning To-Do List

It is true that it’s hard to do tax planning this year with all the open issues.  Still there are some things you can do now that will make it that much easier to react when we are able to fill in the blanks on the unknowns. 

 So here are 5 tax topics to make some decisions about while we wait for Congress to make their decisions on taxes.

 1.  Year end is always a good time to benchmark your retirement plan savings.  Either max out on your tax deductible retirement contributions for the year or convert some of your qualified plans to Roth IRAs.  As mentioned in earlier posts – this is a prime year to convert to a Roth plan if you are so inclined.  In 2010 only you can pay the tax liability on conversions over two years rather than right away.  No penalties.  And payments don’t start until 2011.  If you can afford it, and believe tax rates and / or your income are heading up, this is a must do.

2.  If you’re planning any activities that will lead to big deductions this year, make sure you need them.  If tax rates are higher next year you will appreciate the deduction even more.  Your favorite charity may prefer to get a holiday gift donation, but they’ll still happily take the money in January.  At that point the reward for giving may be larger for doing the same amount of good.

3.  There are still some energy saving tax credits to be gained this year if you’re feeling flush.  (Even if our bank balance isn’t large,  the combination of tax benefits and lower utility bills may make it worth deferring another kind of purchase until the new year.)  You can find the eligible energy tax credit purchases at www.energysavers.gov. 

- One warning here.  Many of our clients confuse the energy saving appliance rebate with this energy tax credit.  They are NOT the same thing.  The credit is for a new furnace or window, not a new washing machine.

4.  Some key education savings vehicles are on the list of tax breaks due to expire at the end of 2010.  It doesn’t hurt to use any education tax breaks to the max while they are there for sure.  For example, The American Opportunity Education Credit of to $2,500 is based on maximum spending of $4,000.  If you haven’t hit that threshold yet you are allowed to include pre-paid tuition for next semester in the year that it’s paid.  Also, if there are books you know you’ll need next semester they also qualify. 

Beware -- If you pay these expenses from a 529 Plan Account they are NOT eligible for the credit.

Speaking of 529 Plans, if you have one and also have money in a Coverdell Education Savings Account, you may want to roll the Coverdell Funds into the 529 plan.  Coverdell Accounts are due to be much less attractive without new legislation after 2010.  The 529 Plans are not on the chopping block.  The transfer from one account to the other is tax free.

5.    In January the reimbursable expenses for Flex Spending Accounts, Health Savings Accounts, Archer Medical and other tax-protected health reimbursement accounts will change.  In 2011 you won’t be able to use money in those accounts to purchase over the counter medications.  (Your doctor can write you a prescription for a drug you could purchase OTC and you can buy it that way.)  Have no idea why this has been changed, but if you’re in a “use it or lose it” plan add non-prescription medications to your holiday shopping list. 



More thoughts on Roth Conversions

Some other item related to Roth Conversions that have come up in client conversations in the past few weeks that I’d like to pass on.

First --  if you are Married Filing Jointly and you both have traditional IRAs you want to convert to Roth plans, the decision about whether to pay the tax in full at conversion or pay it over two years can be made differently by each individual. (See the previous post for more on this.) Even though the decision can be made separately for each social security number, once a taxpayer decides the timing all converted IRAs in 2010 are subject to that election.    

The option to elect to defer the taxes on your conversion is for 2010 only (at least at this point), however the ability to convert regardless of your income will continue.  For people who hit the income limits on contributions to a Roth, and who think tax rates are likely to go up, this creates an opportunity to continue shifting retirement savings. 

The said, even if you want to convert, it may not be practical to convert all your IRAs in one year (and therefore pay all the taxes at once).  But you could make a plan to convert over time, and take the tax hit in a way that fits into your budget. 

 In addition, you still have the opportunity to contribute to a non-deductible IRA and convert that, again without considering income limitations.  One caveat here is that the IRS considers the tax consequences of all your IRAs when you go to convert.  Here’s an example straight from the Practical Tax Expert:

Jane has made 15 $2,000 contributions ($30,000) to her non-deductible IRA.  This year, when the balance in the account is $40,000 she converts it to a roth IRA.  Jane also has an IRA that she established with a rollover from a former employer’s 401(k) plan that has $60,000.  If she converts only the non-deductible IRA into a Roth IRA, she can use only $12,000 of her basis (($30,000/$100,000 X $40,000) and is taxed $28,000 ($40,000 - $12,000).

So the good news you can “re-balance” your retirement portfolio if your “bearish”  on tax rates.  (I’m using that term assuming the definition is that bears think tax rates are going up.  I just can’t make the image work of being bullish on taxes and thinking you’ll have more of them.)  The bad news is that the IRS continues to stalk your retirement savings at every turn.  

Tax Planning Thoughts

While you don’t have to make a final decision until the end of the year, it is worth taking some time now to think about converting your traditional IRA or other tax qualified retirement plan to a Roth IRA.  This decision process requires many assumptions.  My preference is using facts to make financial decisions, but sometimes that option just isn’t available.   

A quick summary on traditional qualified plans vs. Roth IRAs yields the following bottom line.   Are you better off deferring taxes until you are age 70 ½ or should you get it over with now, and then get tax-free distributions from your retirement savings?

• The IRA / qualified plan money is contributed on a pre-tax basis.  If it stays in the plan until after you are 59½ years old, you will pay taxes on withdrawal.  If you try to take the money out earlier, you pay the taxes plus a 10% penalty.  Once you reach age 70½ you have to start taking a specified portion in distributions, as the IRS is done waiting to get the taxes due on that money.  You age-out of being able to contribute to a traditional IRA once you have to take those mandatory distributions
• With a Roth IRA, the contributions are made after taxes.  Earnings may be withdrawn without tax or penalty if you meet the 59½ age threshold and the money has been in the account at least five years.  There are no mandatory distributions.  So while you don’t get the turbo charge of pre-tax contributions and then getting deferral on the growth, on the other hand, what is in the account is yours to keep.    The Roth IRA doesn’t have an age restriction for contributions, but there are income limits that cause many upper income people to be ineligible for this type of plan. 

This brings us to 2010 -- a year that is notable because the income limitations on converting qualified retirement plans to a Roth have been removed.   This means you can roll over money in other qualified pIans regardless of your income.  In addition, moving the IRA into a Roth will not trigger tax penalty even if you haven’t reached the age where the IRA can be accessed.  However, all taxes owed must be paid.  If you make the decision to do this before the end of 2010, you can elect to pay the taxes over two years -- waiting to make the payments in 2011 and 2012.

Here’s where the assumptions stuff comes into play.  Normally, using the time value of money approach to managing your finances, paying later is always better.  However, if the Bush tax cuts expire in 2011, you could pay more in taxes that year than you would have if you took the hit in 2010.  Another assumption to watch out for is the Medicare surtax on investment income.  This tax is scheduled to start in 2013, and if you are in a higher income bracket you won’t pay it on your Roth distributions, but you will on your traditional IRA. 

One offset to all the crystal ball gazing skills involved in the conversion decision is talking to a tax advisor.  While it’s still an assumption, I’m convinced a thorough review of all your specific considerations this year is an especially good investment.