Switching IRAs could lower taxes

PERSONAL FINANCE

April 12, 2009|By EILEEN AMBROSE

Joe Cunningham is convinced that income taxes are going up, even for middle-class taxpayers like him.

Attempts to fix the economy can't work without an enormous tax increase, the Pasadena retiree says: "It will be on everybody who pays taxes, which ultimately always is the working class or retired working class."

For that reason, the 68-year-old wants to convert his traditional individual retirement account to a Roth IRA. By doing so, he'll have to pay regular income tax now on the funds he transfers to the Roth. But from then on, money coming out of the Roth will be tax-free. So no matter how high taxes go, Cunningham won't have to worry.

If he's right about taxes, his timing to convert couldn't be better.

Tax rates are exceptionally low now. IRA account values also have fallen with the markets, so there are fewer gains to tax during a conversion. And the outlook for higher federal income taxes is good - at least for those in the top two brackets. President Barack Obama favors raising the rates on families making more than $250,000. Even if Uncle Sam doesn't raise income taxes on those making less than that, cash-strapped states might do so, says Ed Slott, an accountant and IRA expert. Another factor favoring the Roth.

IRAs essentially give you the choice of getting a tax break upfront or on the back end.

A traditional IRA rewards you on the front end, where contributions are often deductible. Once you take money out in retirement, you pay regular income tax on the earnings and any deductible contributions.

Money goes into a Roth after taxes have been paid on it, but comes out tax-free in retirement. Basically, you're better off with a Roth IRA if you expect to be in a higher tax bracket in retirement than today.

So should you, like Cunningham, make the switch?

There are several factors, besides the tax outlook, you need to consider.

Right now, only singles and married joint filers with adjusted gross incomes up to $100,000 can convert a traditional IRA into a Roth. Next year, that $100,000 cap disappears. And if you convert to a Roth IRA next year only, you will be able to spread the tax bite over 2011 and 2012.

You shouldn't convert if you will need to take the money out of the Roth within five years. If you do so, you will trigger taxes on the earnings withdrawn, Slott says. Plus, you can get hit with a stiff penalty if you're under age 59 1/2 .

"There is really no benefit today, or next year or two years" for converting, says Jim Sloan, a financial adviser in Friendswood, Texas. "The benefits are five, 10 or 15 years from now" when your Roth has had time to grow, he says.

Don't convert if you don't have money outside the IRA to pay your tax bill. Using IRA cash to pay taxes means fewer dollars going into the Roth. Plus, that cash will be subject to an early withdrawal penalty if you're under age 59 1/2 .

As an alternative, you could convert only part of your IRA to lower the tax bite to an amount you can afford to pay out-of-pocket, Slott suggests.

Cunningham plans to convert half the money in his IRA to make the tax bill more manageable. He also wants to leave the Roth to his three children, so the money likely won't be touched for many years.

For retirees who don't need the money, the Roth has another attractive feature: No required distributions after age 70 1/2 .

To see whether a conversion makes sense for you, check out the Morningstar IRA calculator on T. Rowe Price Associates' Web site at www.troweprice.com.

Of course, there is no guarantee taxes will go up.

For that reason, Joel Dickson, a tax specialist with the Vanguard Group, recommends keeping a mix of traditional and Roth IRAs as a hedge against whatever happens to tax rates.

If you regret converting, you have a certain amount of time to switch the Roth back to a traditional IRA and get the money you paid in taxes returned, Slott says.

You will need to contact the custodian of your IRA and file Form 8606 with your federal tax return to convert, Sloan says.

IRAs are highly complicated. There are so many potential traps that if you're not quite sure how to undertake a conversion, seek the help of a professional.

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