The Roth IRA Silver Lining
The market is in turmoil these days, but there is a bit of a silver lining for people who might be thinking about converting their traditional IRA to a Roth IRA. If you're qualified, converting now could minimize the taxes you would have to pay. It doesn't make sense for everyone to convert, but if it makes sense for you, this could be the ideal time.
By Ann Coleman (TMF AnnC)
December 1, 2000
Anyone else hyperventilating when you look at your portfolio? For the first time this year I am seriously into negative territory -- for my entire portfolio, not just the stocks at the bottom of the page. My entire portfolio is getting perilously close to half of what it was just last March. Compared to that, the Foolish Four's drop of 20% is comforting.
I am hyperventilating, but I'm not losing sleep. Things are definitely ugly, but I'm not ready to revise my retirement plans from houseboat to house trailer just yet. For one thing, although there are some very disappointing earnings numbers coming out, most of the sell-off seems to be attributable to post-election uncertainty, not the death of the economy. Political uncertainty is something investors just have to live with.
I'm pretty sure that Nokia <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NOK)") else Response.Write("(NYSE: NOK)") end if %> will still be selling cell phones all over the world two years from now, DaimlerChrysler <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DCX)") else Response.Write("(NYSE: DCX)") end if %> will still be selling minivans, and more and more households will get connected to the Net. In the long run, we're all dead; but, prior to that, the economy, technology, and life in general look pretty good. The short run is a different matter.
Convert traditional IRAs to Roth IRAs now?
There is a silver lining to this mess. If you've been thinking about converting part or all of your IRA to a Roth IRA, now is the time. Converting when your portfolio is down can save you a boatload in taxes.
When you convert, you pay taxes on the returns your portfolio has generated and on any contributions that were tax deductible. Contributions that you didn't deduct (if you can document it) are not subject to taxes.
Unfortunately, all of this cash goes right on top of your regular income, so it will be taxed at your marginal tax rate and could even push you into a higher tax bracket. That's the downside. The upside is that you never have to pay federal taxes on that money again, and it can be passed to you heirs without paying income taxes either (although it will be subject to estate tax).
The silver lining part is that if you can time your conversion when the market value of your stocks is temporarily down, you pay lower taxes on the conversion. The tax is assessed on the value of the account at the time of conversion, not at the end of the year. So, there's a window of opportunity here for some folks.
Example: Say you had a traditional IRA portfolio valued at $100,000 a few months ago, and its value has dropped to $70,000 (all contributions were deductible). Convert it to a Roth IRA today and you'll pay taxes on $70,000 instead of $100,000 even if it bounces back right away. That could save someone in the 28% tax bracket $8,400 in federal income taxes now, and potentially tens or hundreds of thousands of dollars in taxes during retirement.
It's so much more fun to have a Roth IRA! The prospect of spending my retirement not paying taxes on my IRA withdrawals is just so much more exciting than envisioning myself slaving over TurboTax every April until I'm too feeble to click my mouse.
Now, this is a fairly limited silver lining. For most people, it's more like a thin spot in the clouds that lets a little sunbeam through to shine on your neighbor instead of you. Still, for those who enjoy the fine sport of tax minimization, it's a ray of light in an otherwise dismal financial picture.
Know the limits
There are limitations on converting IRAs to Roth IRAs. Your adjusted gross income (AGI) must be less than $100,000 -- and, for some unfathomable reason, that applies to married couples as well as singles. Don't worry, the $100,000 AGI limit doesn't include money from the IRA conversion. You do have to add the conversion to your income when calculating your taxes for the year, but not for the purpose of deciding if you qualify to convert. Click here for the IRA publication with all the skinny.
Conversions make the most sense when you have the cash to pay the taxes without tapping the IRA. If you take the money for the taxes out of the IRA account, you get hit with the 10% early withdrawal penalty on the amount withdrawn. Paying the taxes on a conversion isn't a "qualified distribution."
Generally, if you have to take the money out of the account and pay the 10% penalty, the conversion doesn't make sense because it reduces the account's ability to compound. In other words, it might be better to let the account grow and just pay the taxes when you retire and take the money out.
However, if you expect to be in a higher tax bracket when you retire than you are this year, paying the taxes out of the account now can make sense. Most retirement planning assumes that you will be in the same or a lower tax bracket, but for some people -- especially if you are on the getting-started part of your earnings curve -- it can make sense.
The Roth Conversion Calculator can help you figure out if the conversion works for you. If you have an IRA, check the calculator out, and if it looks like the conversion is advantageous for you, get started right away. Most online brokers will let you download the paperwork for the conversion right from their websites.
I like to hope that time is very critical here because the market will pop back up as soon as the dust settles in Florida. On second thought, you might have a few days of leeway.
Fool on and prosper!
