Your Financial Plan: Transition & Retirement Planning

A Depressed Market Is an Ideal Time for Roth IRA Conversions

You can save big on the income taxes you’d normally incur by removing funds from a tax-deferred IRA.

For retirement investors, good news has been hard to find lately. But here’s a small silver lining for the dark clouds hanging over the market: There’s never been a better time to convert an IRA to a Roth account. If you’ve been thinking of converting some or all of your IRA assets to a Roth, this is a great time to make your move, since you can save big on the income taxes you’d normally incur by removing funds from a tax-deferred IRA.

 “If you want the benefits of a Roth, the cost of the entry is the current income tax on the conversion,” says Bob Trinz, senior tax analyst from the Tax and Accounting business of Thomson Reuters. “If you think the market has an upside, the time to make a conversion and take the tax hit is now.” However, until 2010, you can only make the conversion if your modified adjusted gross income is $100,000 or less. Also, you can’t make the move if you are a married person filing a separate return.

Roth IRAs have gained popularity in recent years but represent a much smaller portion of overall U.S. retirement holdings than traditional IRAs. They’ve been more popular with younger investors, who tend to be in lower tax brackets—but they’re worth considering for people closer to retirement age, too.

Traditional IRAs and 401(k) plans are an essential part of any retirement savings plan—but they’re not the complete answer. Withdrawals from tax-sheltered accounts can have negative consequences for your overall tax situation in retirement, since your brackets can be somewhat fluid after you stop working. Sometimes, taking a distribution from a tax-deferred account can put you into a higher bracket than you want to be in, boosting your tax bill.

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With a Roth IRA, you’ve paid the income tax upfront, since you invested post-tax dollars. That means your withdrawals are tax-free, so long as the account has been open five years and you are at least 59-1/2 years old.

Another major Roth benefit is withdrawal flexibility. Unlike traditional IRAs, you aren’t required to take annual distributions from a Roth when you turn 70 1/2. That makes Roths a good vehicle for intergenerational wealth transfer, as you can simply bequeath holdings to your heirs as tax-free income. But your heirs generally will have to take minimum payouts from the inherited Roth over their lifetimes.

Shorter-term, unfortunately, today’s down market means that the required minimum distribution rules amount to a form of forced selling. The minimum distribution for a year is calculated against your IRA end-of-year balance the previous year; for example, in 2008 withdrawals were geared to the higher market valuations that prevailed at the end of 2007.

For example, if you turn 73 this year, and your IRA portfolio was worth $500,000 at the end of December, your RMD this year would be $20,243, according to Trinz—even though the account is now worth much less. If you fail to take the distribution, you’ll pay a steep 50 percent penalty on the amount you should have withdrawn but didn’t.

You can also get a do-over if you convert from a traditional IRA to a Roth IRA and then quickly the market tanks; this would leave you with an artificially high tax bill even though your portfolio has now fallen. This can be done by “re-characterizing” the conversion back to a traditional IRA via a trustee-to-trustee transfer. “Fortunately, the conversion can be treated as if it had never been made by re-characterizing it,” Trinz says. You still have the option to reconvert those same funds to a Roth, benefiting from the current lower valuation.

Congress and the new Obama Administration could give investors even more relief by waiving RMDs entirely, but Trinz doesn’t expect to see that happen. “When IRAs were created, Congress wanted to make sure they would be used as a retirement savings vehicle, and not as an intergenerational tax shelter,” he says.

© 2008 Tribune Media Services Inc.