Let’s do a quick survey: do you believe taxes are going up in the future, going down, or staying the same? Your answer may help determine whether or not you should convert your Traditional IRA into a Roth IRA.
Unlike a Traditional IRA, a Roth IRA may increase your retirement savings by providing tax-free growth and distributions without taxes when you receive them for you and your beneficiaries. The reason some retirees don’t take advantage of this is simple: you have to pay taxes on the amount that you convert to a Roth IRA in the year that you convert.
For many retirees, paying the taxes now is counter-intuitive and a sticking point that prevents them from making the decision to convert. Even though it may not feel like it, converting and paying the taxes now may benefit you in the long run. This is because you pay taxes at current rates versus what may be higher rates in the future. Even though taxes always feel too high, we’ve had falling rates since the Reagan years and are currently in the lowest tax environment we’ve ever had.* If taxes go up in the future, converting now while the rates are low could save you thousands on your total tax bill.
So how likely is it that your tax rate will increase? Let’s look at three ways taxes could potentially go up.
First, if the feds don’t act to extend the current tax law by the end of this year, some of us may face higher taxes when the Bush tax cuts expire.* Paying the tax this year may lock in the current, lower rates.
Second, tax rates may rise when our leaders face the hard truth that our high national annual deficits and growing debt are unsustainable and that taxes may be raised to support our basic government activities. Some of us may remember that famous line, “Read my lips, no new taxes”, but whether our leaders are Republican or Democrat, eventually they must face the mounting deficit and debt. Tax increases may be implemented as a solution.
The third, often overlooked, way taxes can increase is if you’re married and your spouse passes. It may become more costly when you classify as single according to the IRS, because current tax laws benefit married couples in many ways, including lower income levels for the same tax rates.** On top of grieving for a lost spouse, the tax system may increase the tax bills for single individuals the year after their spouse dies. It may become more costly to convert to Roth after a spouse passes, assuming you have no dependent children.
Consider this client’s recent experience. The client’s husband passed away after a long illness. He left her with sufficient income from his pension, social security, and investment income, totaling $75,000. But this year her tax bill is $4,000 more, or 40 percent higher than when he was still living, with the same $75,000 income. Converting to a Roth IRA is more difficult for her now, with $4,000 less to start. The decision to convert is more costly than it would have been had she decided to convert when she was still married.
Another client’s wife passed away last summer. The couple were the same age and had been partners for forty years. The widower met with me to review his financial and tax plan, and we did the math. It was hard for him to learn that, because he has turned 70½, he is now legally required to take out an additional $20,000 from his $500,000 Traditional IRA, in addition to his pension, social security, and investment income, totaling about $80,000. He doesn’t need his IRA distribution, but by law he has to take it. His taxes increased approximately $9,500 on $20,000 of IRA income. “Ouch” was not the word he used to describe his shock.
Remember this key point: When you turn age 70½ you are required to make withdrawals on your Traditional IRA, but there is no required minimum withdrawal from a Roth IRA.
The more income you have, the more expensive your tax bill becomes. Compound that with the potential for tax increases, and the potential for reduced retirement income is a concern for some retirees. Building a proactive strategy may allow you to keep more of your money; as opposed to letting the government tax you for more of it. You choose!
Working with a competent financial representative who knows how to navigate IRAs and can assist you in converting to a Roth IRA may benefit you and your beneficiaries for many years to come.
Adam Wolf CPA, CFP® is Executive Vice-President of Magdalein and Stratton and has worked for the past fourteen years to help clients keep more of their hard-earned money. He is holding seminars on Roth IRA Conversions during November and December. RSVP today by calling Sarah or Kate at (904) 425-0943.
*Historical tax information for this article found at www.taxfoundation.org
**Information can be found at www.IRS.gov as of October 30, 2012.
Disclosures: This is not a comprehensive overview of Roth IRA conversions and is for informational purposes only. The information has been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. The information is not intended to be used as the sole basis for financial decisions, nor should it be construed as advice designed to meet the particular needs of an individual situation. Please seek advise from qualified financial, legal and tax professionals prior to considering a Roth IRA conversion. Any transaction that involves a recommendation to liquidate funds held in a securities product, including those with in an IRA, 401(k) or other retirement plan for the purchase of an annuity, can be conducted only by individuals currently affiliated with a properly registered broker/dealer or registered investment advisor. Distributions can be subject to ordinary income tax, and if taken prior to age 59 1/2, a 10%federal additional tax.
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