ROTH
CONVERSIONS MAY BE MORE ATTRACTIVE FOR SOME RETIREES
Affluent
retirees who have wanted to convert sizable traditional individual
retirement accounts into Roth IRAs but weren't eligible because
of income restrictions may find 2005 the year to make the conversion.
Starting in 2005, an obscure
provision in a 1998 federal tax act allows retirees age 70 1/2 or
older to exclude from their income the required minimum distributions
from traditional IRAs when determining conversion eligibility. Consequently,
conversions should become a possibility for some affluent retirees,
say some financial planners.
To understand how this all works,
let's quickly compare traditional and Roth IRAs. A traditional IRA
is funded with pre-tax dollars, it grows tax deferred, and withdrawals
are taxed at the owner's ordinary income tax rate. Furthermore,
the owner must begin taking minimum mandatory withdrawals after
turning 70 1/2. These minimum withdrawals eventually drain the IRA
account.
A Roth IRA is funded with after-tax
dollars and grows tax deferred. Withdrawals are tax free as long
as the account has been open for at least five years and the owner
is 59 1/2 or older, otherwise there are penalties for early withdrawals.
Furthermore there are no mandatory distributions beginning at age
70 1/2. It can be left untouched until death and passed on income-tax
free to heirs.
This makes Roth IRAs more attractive
to affluent retirees who may want to pass IRAs on to their heirs
or who may want to conserve IRA assets until much later in life
to pay for such things as high medical or long-term care expenses.
So, if you have traditional IRAs you may want to convert them to
Roth IRAs based on your needs. The catch is that you have to pay
income taxes on the amount you convert, and you can’t convert
in a year in which your modified adjusted gross income (before the
conversion) exceeds $100,000.
That's where the 1998 provision
helps. Those required withdrawals are often a significant source
of income for retirees, even if they don't need the money at that
time. And until now, those mandatory withdrawals counted toward
the modified AGI. But they won't starting in 2005.
To give you an example, assume
that you earn $70,000 in non-IRA income, you are age 72, and you
have $800,000 in a traditional IRA. Your required minimum distribution
for that IRA is $31,250. By my calculations, your total modified
AGI is $101,250, you wouldn’t qualify for a Roth conversion
in 2004. But you would qualify in 2005 because that $31,250 no longer
counts toward the $100,000 conversion limit.
But even if you now qualify for
a conversion, you would still need to weigh other factors in deciding
whether converting is right for you. First, all that money that
comes out of the traditional IRA for a conversion will count as
income for that year, and may push you into a higher tax bracket.
You could end up with a hefty tax bill.
On the other hand, some tax experts
argue, tax rates seem unlikely to go any lower, and while others
believe that they may rise in the future to offset the growing federal
deficit. So it may be a matter of gettin' while the gettin's good
depending on your risk factor
It may help if you can afford
to pay that tax bill with money from outside the IRA withdrawal.
That could allow you to roll the full amount into the Roth IRA.
Other tax factors include the conversion's impact on state income
taxes and the alternative minimum tax, so you'll want to work closely
with a tax expert before taking any action.
Are potential creditor lawsuits
a risk for you? Federal law does not shield IRAs from creditors.
Many states do, but not all include Roth IRAs in that protection,
so you may want to see what your state's laws are before converting.
Lastly, keep in mind that if
you do convert, you have until October 15 of the year after the
conversion to switch back to the way things were (your conversion
tax will be refunded). You may want to do this if your income for
the conversion year unexpectedly exceeds $100,000. You may also
want to consider reconverting if the value of your new Roth has
dropped substantially since the conversion. You would reconvert
to a traditional IRA, wait 30 days, and convert again with the lower
account value (thus incurring lower conversion taxes than you incurred
in the original conversion).
Again, confer with your tax advisor to see if this strategy
is right for you.
This article
was produced by the Consumer Affairs Dept. of The Financial Planning
Association and provided to you courtesy of Terry P. Welsh, CFP,
Ketchikan, Alaska. If you have any questions or concerns regarding
this, or any other financial topic, please call me at 1-907-225-0619,
or click on the "CONTACT US" button to arrange for a free initial
consultation.
Back
To Newsletter Archive
|
