Financial WellnessTo convert your IRA to a Roth IRA or not to convert; that is the question!
There are some big changes in 2010 for anyone with an IRA. For the first time in history, you will be able to covert your IRA over to a Roth IRA. Why convert? Before we get into the rule changes for 2010, lets review the differences between the Traditional IRA and the Roth IRA.
Traditional vs. Roth IRAs
IRAs can be an effective investment vehicle for retirement savings because they both grow tax-deferred. They generally come in two flavors: Traditional and Roth.
- Traditional IRAs allow for pretax contributions (i.e., pay taxes later; avoid them now).
- Roth IRAs allow for post-tax contributions (i.e., pay taxes now; avoid them later).
The new rules
Through 2009, only individuals with adjusted gross incomes less than $100,000 could convert qualified dollars to a Roth IRA. Beginning January 1, 2010, however, the $100,000 limit was eliminated, so individuals who were previously unable to convert to a Roth IRA can now do so.
When you convert to a Roth, you pay income tax on the taxable dollars that are converted. One benefit of the new rules, however, is that amounts converted in 2010 will be eligible for a special tax option. Eligible individuals electing to convert in 2010 will be able to spread out the income tax payment in equal installments over two years. If they elect to defer taxes, they may pay 50 percent of the tax burden in 2011 (generally due on April 15, 2012) and the remaining 50 percent in 2012 (generally due on April 15, 2013). (Note that taxes due from conversions made after 2010 will be due in full in the year of conversion.)
Reasons to consider a Roth conversion
There are many attractive benefits of converting to a Roth IRA, but whether or not it makes sense for you depends on your situation.
Tax-free withdrawals. Because retirement can now span 20 years or more, tax-free withdrawals have become an attractive feature. When you do a Roth conversion, you are paying taxes today in order to receive a qualified, tax-free distribution in the future. One of the reasons to think about setting up or converting to a Roth IRA is if you believe your income tax rate will be higher in the future than it is today.
You may take qualified tax-free distributions from a Roth IRA after you have had it for five years and when the distribution is for one of the following reasons: death, disability, age 59 ½, and first-time home purchase.
No required minimum distribution (RMD). Unlike Traditional IRAs, Roth IRAs do not require that minimum distributions begin at age 70½. This allows those who don’t need that income stream in retirement to pay the taxes now, keep all of the Roth IRA money invested beyond age 70½, and avoid the annual income tax burden that exists with RMDs.
Hedge against rising income taxes. No one has a crystal ball, but it is conceivable that taxes will increase. When you look at marginal income tax rates over the last few decades, only once during a five-year period has the top marginal income tax rate been less than today’s current rate of 35 percent.
An effective estate planning strategy. If you want to preserve assets for your heirs, then a Roth conversion may be an effective estate planning strategy. Because distributions from a Roth IRA are not required until a nonspouse beneficiary inherits the accounts, more assets can be preserved for future generations. And although nonspouse beneficiaries must take RMDs, they can generally stretch those distributions based on their life expectancy—and the income is free from federal tax.
Questions to consider
Still, talking to a qualified professional can help you explore the following important questions:
- Do I expect tax rates to be higher or lower when I retire?
- Do I have a large percentage of assets in Traditional IRAs? If you have a concentration of assets in traditional IRAs, you may want to consider converting some of those assets as a way to hedge against future tax increases. Supplementing retirement with nontaxable income may increase the likelihood that you will be in a lower tax bracket during retirement.
- If I convert, can the conversion taxes be paid from a source outside of the IRA? Yes. Using IRA assets to cover the tax bill will typically result in more taxes being paid and may involve early withdrawal penalties, depending on your age, so it is generally better to pay the tax owed with funds from outside the retirement account.
- Will I need access to the money within five years? Remember the five-year requirement. If you think you will need access to the assets, then a Roth conversion may not be right for you at this time.
- Do I wish to leave tax-free income to my beneficiaries? As previously mentioned, a Roth IRA can be used as an effective means of preserving assets for heirs.
- Do I have retirement accounts that have suffered losses? You may have accounts with balances that aren’t as high as they were prior to the market downturn in 2008. Converting these accounts to a Roth IRA while the values are down may result in a lower income tax.
New Year - New Financial Wellness
Okay it's 2010.
Time to roll out a new calendar and a fresh list of resolutions. For many of you, that may mean getting to the gym more frequently or starting that diet you put off until after the holidays. But how many of you have put financial planning on your list? I think I hear crickets chirping.
Like most daunting tasks, it’s easy to do nothing at all when we are overwhelmed. Neither of these approaches is productive or beneficial over the long term. Once you’ve acknowledged this, the next step is to take action and take back control of your financial life. Being proactive will empower you. Here are some ways to get started.
Consider what’s important to you and why
Start by making a list of financial goals. You may want to retire comfortably, buy a second home (or a first home), send a child to college, or purchase a new car. You already know what’s important to you, but you may not spend a lot of time thinking about why certain items are on that list. For example, you may think having money is important to you. Who doesn’t feel that way? But the reason why money is important is likely different from one person to another.
When you explore the reason why things matter to you, what you’re really doing is thinking in terms of concrete goals rather than broad concepts. This is a great way to start taking charge of your finances because you can then generate an inventory of specific goals you want to accomplish and then how you might fund them.
Develop a financial plan
It’s a bit difficult to create a complex financial plan on your own, but what you can do is take action by finding a licensed professional to assist you. The goals that you have identified are too important to leave up to chance.
Dispelling myths about financial planning
There are numerous reasons why people choose not to take action during challenging financial situations, especially when it comes to developing a financial plan. There are myriad myths surrounding financial planning, but the following are probably the most common. Don’t let them stop you from taking smart action.
Myth #1: Financial planning is for the wealthy. Not true. Financial planning is for anyone who wants to take control of his or her financial goals. Consider instead that a lot of wealthy individuals may have become wealthy because they did financially intelligent things like create plans and act on them.
And what does wealthy mean, anyway? The fact is, even millionaires often don’t define themselves as wealthy and may think that they belong to the middle-class or upper middle-class. We’ve come up with so many different terms for people’s economic standing that it’s hard to say where you fall.
Myth #2: I don’t need insurance until I’m old. Or, I have enough insurance. The amount of insurance you need is based on several factors; age is only one of them. Additionally, we often purchase some form of insurance and then forget about it, thinking we’ve attained what we need. As life circumstances change, your need for insurance may change, too.
Insurance can be a safeguard for your personal income, your standard of living, and your legacy no matter what your age.
Myth #3: I can’t afford professional advice. False. After the markets bottomed out in 2009, many people watched their assets decrease; some may be suffering from other economic distress like job loss. The short-term cost of professional advice, however, may be minimal compared with the long-term cost of not getting any help. Consider the cost of your sanity, the stress on your family—and the idea that you could gain some peace of mind by tackling these issues and having a solid game plan.
It’s reasonable to assume that people who already had financial plans in place before the markets started to fall are feeling more comfortable during these tough times because they know that they’ve taken action.
At a minimum, you may want to check out the following websites:
- www.finance.cch.com
- www.mint.com – budgeting information
- www.dinkytown.com – financial calculators
- www.bankrate.com – bank lending rates
- www.annualcreditreport.com – credit reporting information