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June, 2004 Tax Tip

 

 Time May Soon Be Ripe To Convert To a Roth IRA

 

When may it be a great idea to unnecessarily pay your taxes ahead of time?  Let me tell you.

 

On January 1, 2005  many affluent retirees become eligible, under a 1998 tax provision, to convert their traditional IRA accounts into Roth IRAs.  That's why now may be the proper time to consider a conversion.   Combine that with the fact that the federal budget deficit is mounting, so tax rates are not likely to go any lower and could soon head higher, making Roth conversions even more attractive now.

 

A traditional IRA is funded with pretax dollars.  Investments grow tax deferred, and withdrawals are taxed at ordinary income rates, with a current top federal rate of 35%. A Roth is funded with after-tax dollars, but any withdrawals made after five years and past age 59 1/2 are tax free.  The longer one lives, the more beneficial a Roth.  While you must begin withdrawing funds from a traditional IRA the year after you turn 70 1/2, you (and your spouse) never have to take money from your Roth, if you so choose. In fact, you can leave all of the Roth to your children or grandchildren and they will have years or even decades (depending on their ages when they inherit) to deplete it.

 

When you convert, the value of your traditional IRA must be included in your income, you pay federal and state tax on that amount, and then you convert the account into a Roth.  But wait – a monster rears its ugly head!

 

A tax provision designed to prevent those with very high incomes from benefiting from a conversion allows a conversion only to those with modified adjusted gross income (“MAGI”) of $100,000 or less.  This $100,000 limit applies whether you're single or married filing jointly (you can't convert if you're married and file separately).  Included in the MAGI is any mandatory payout from a traditional IRA.

 

So what does the 1998 tax provision mentioned at the outset have to do with this?   As of January 1, 2005  those 70 1/2 and older, who are forced to take distributions from a traditional IRA, won't have to count those forced minimum payouts in calculating that year's MAGI.   As an example, suppose a 72-year-old widow has a $1 million IRA and $80,000 a year in non-IRA income. The mandatory payout from her IRA is $39,000.  She can't convert this year as her MAGI would exceed $100,000, but in 2005 she can. 

 

While only older IRA owners benefit from this provision, potentially anyone can at some time find a window of opportunity to convert.  For example: those who depend on low-yielding investments for income, people between jobs, and small business owners who are able to use current generous equipment expensing and bonus depreciation provisions to reduce their taxable incomes may certainly want to consider converting.  If such an opportunity knocks, answer the door!

 

Why would anyone elect to pay a tax now that could be deferred?   Simply because the tax you pay now may come back to you many times over by your not having to ever pay tax on the anticipated appreciation in the Roth account over time.   This is particularly true if you pay the taxes due on the conversion with funds from outside the IRA in order to allow the maximum appreciation within the Roth. 

 

There are other factors to consider when making the conversion decision, including state taxes and the alternative minimum tax.  There may be tax planning opportunities to alleviate the effect of the negative factors.   Converting to a Roth is essentially risk free in the short term because the government gives you until October 15th of the year after you convert to switch back to a traditional IRA.   If it turns out your income was more than $100,000 in the conversion year, you'll be required to convert back to a traditional IRA.  Or, if your Roth has dropped in value, you can undo the conversion by the next October 15th, get a refund of the conversion tax, and try the conversion again after waiting just 30 days. 

 

Proper investment planning with your Roth or Roths (e.g. you can have separate Roth accounts for different investments) can really give you the best of all worlds tax-wise.



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