If your Individual Retirement Account (IRA) consists of stocks and stock funds, 2008 has been a devastating year. On top of the teetering economy and stock market debacle, there is also the possibility – probability – that the United States and its taxpayers will soon need to pay the piper for our government’s massive spending sprees and deficits. Since we face such an uncertain future for retirement planning, wouldn’t it be nice to make some lemonade out of lemons?
Here’s the recipe
Assuming some or all of your retirement assets are in a traditional IRA, and assuming a large portion of that IRA is invested in stocks or equity funds, -this is the year to consider converting your traditional IRA (T-IRA) to a Roth IRA (R-IRA).
Why convert in 2008?
If you are a typical IRA equity holder, your stock portfolio has decreased in value somewhere between 25 and 45% in 2008. Best-case example, an October 2007 $100,000 portfolio is currently worth $75,000.
As you probably know, when you take money out of a traditional IRA, the amount you withdraw is taxed as ordinary income. You do not get the advantages of the capital gains or capital loss provisions of the tax code with a T-IRA. Consequently, the lower the value of the assets you convert to a Roth IRA, the less ordinary income tax you will pay on the conversion. In our example, the current T-IRA value is $25,000 less than it was in 2007, therefore the tax on the conversion will be some $6,000 less if you are in the 25% federal tax bracket.
Further, you may currently be in the lowest tax bracket that you will ever enjoy. If that is true, you will also pay fewer dollars in ordinary income tax if you make a conversion before your tax rate changes.
It may indeed be a prudent time to convert your T-IRA into an R-IRA while stock prices are low, and you are in a lower tax bracket. After the conversion, and by definition, your future accumulation and eventual withdrawals from your new Roth IRA will be tax-free.
Do you need to convert the entire amount in your traditional IRA account?
It is not necessary to convert the entire $75,000 in the example T-IRA, but for our purposes, we will assume that is what you will do.
Important Note
To gain the greatest tax advantage from a conversion, you must pay the tax bill from a source outside the IRA thereby converting all the dollars from the traditional IRA into the Roth IRA. An often overlooked long-term advantage of a conversion is that the result creates an effectively larger IRA because the number of dollars in the new Roth IRA is the same as the number of dollars in the old traditional IRA, but they are now after tax dollars.
In our example, you pay ordinary income taxes (from a source outside the IRA) of approximately $19,000 (assuming a 25% federal tax bracket and no state income tax) on your $75,000 T-IRA, and convert the entire T-IRA amount of $75,000 into an R-IRA. The amount of shares of stock that you transfer remains constant. When the stock market recovers, which it has always done in the past, and your $75K returns to the glory days of 2007 and beyond, you can withdraw part or all of your account, -and all of that great appreciation, is distributed to you tax-free!
More reasons to think about converting now
By converting to a Roth IRA, you can avoid the requirement to take yearly minimum distributions at age 70 ½, – leaving more for your heirs if you do not use the money in your lifetime.
The conversion process is quite simple, and the bank or investment company that holds your T-IRA can help you with the paperwork.
Sounds good – so what’s the catch
There really isn’t a catch, but there is a restrictive income test. In the case of the Roth IRA, your Adjusted Gross Income (AGI) cannot exceed $100,000, regardless of your tax filing status, e.g., single, or married filing jointly – both have the same $100K adjusted gross income limit. The limit will change in 2010, so if you do not qualify now, stay tuned.
The income test can be a problem for individuals or families that do not know their exact incomes until after the first of the year when they tally their W2s from work, and 1099s from banks and investment companies. However, if you know for sure that your AGI will be less than $100K, or even if you suspect it will be less, you can convert to a Roth IRA today.
If you are wrong, and your AGI exceeds the $100K limit, you can undo the conversion using a process called “Recharacterization.” Recharacterization is not difficult, but if you have already filed your tax return, you will need to file an amended return and claim a refund. The government also gives you ample time to recharacterize. For conversions done in 2008, you can recharacterize up until October 15, 2009.
What if you don’t convert now?
The obvious consequence of not considering a conversion to a Roth IRA is that your presently depressed $75,000 stock holding will hopefully rebound to a far larger amount of money in the future. If that appreciated amount is held in a traditional IRA account – and income tax rates increase – the $75K and all the growth will be subject to a higher ordinary income tax rate when you withdraw the money.
Ready to act?
As a prudent investor, and before you take any action, you should ask your tax advisor if there are any circumstances that would make a Roth conversion inappropriate for you. As we all know, “The devil is in the details, –and the tax code.”
