Saturday, October 31, 2009

Should I Convert My IRA to a Roth IRA?

The decision to convert your IRA to a Roth IRA should be based on an evaluation of the benefits and your unique financial situation.

During 1997 I posted an entry to this site detailing the provisions of the Tax Reconciliation Act of 2005 that allows investors to convert their traditional IRA to a Roth IRA without consideration of income limitations that currently prevent investors with adjusted gross incomes in excess of $100,000 from converting.  The Act also allows investors to pay the resulting tax bill over the 2011 and 2012 tax years.  Effective January 1st of 2010 investors will need to evaluate whether a conversion is in their best interest.

I would love to be able to provide a simple list of criteria where an investor can decide whether they should convert.  However, such a list is not possible because the answer is different for everyone.
However, I can suggest several items that should be considered in your evaluation.  The list generally consists of your current marginal income tax rate, your expected marginal income tax, when and if you expect to withdraw the money from the IRA, and your current age.

The tax rate consideration is relevant because you will need to pay income taxes on the amount converted based on your current marginal income tax rate at the time of conversion.  If you anticipate your marginal tax rate to increase dramatically during the expected withdrawal period, it would lead you to consider converting now.  Alternatively, if you expect your marginal tax rate to decrease during the expected withdrawal period, it would lead you to consider converting at a later date or possibly not at all.

If you never expect to withdraw the money, you should consider converting to a Roth.  A Traditional IRA is subject to Required Minimum Distributions as required by the IRS beginning at age 70 ½.  The IRS wants their tax money at some point and if you have not taken the money by age 70 ½, they require you to begin withdrawing the money based on your life expectancy so that they can tax you on the withdrawn amount.  One of the primary advantages of a Roth IRA is that it does not have Required Minimum Distribution requirements.

Another consideration relevant to conversion is your current age.  A younger person has more time to make up for the tax paid on the converted amount.  Alternatively, an 80 year old person can convert to a Roth IRA and pay the tax bill but they are not as likely to live long enough to allow for the tax-free growth to make up for the income taxes paid.

A final consideration is whether the investor has enough money outside the IRA to pay the income tax liability related to the conversion.  If cash is not available outside the IRA to pay the tax, it is not likely for conversion to be beneficial because using IRA money to pay the tax mathematically offsets the benefit of the conversion.

These are just a few of the factors that should be considered in evaluating the benefits of a conversion to a Roth IRA.  You should consult with a financial advisor to discuss your unique situation.

Posted by Ron on 10/31 at 05:05 AM
IRAs

Friday, October 16, 2009

Real Returns

Focus on the items that really impact financial security and ignore the latest investment fads that lack staying power.

The recent trend has been for investors to become enamored with the latest “hot” investment option.  I believe that rather than spending significant energy looking for the next “hot” stock or the next great investment region of the world that instead investors should focus on the factors that will likely lead to the real accumulation of wealth.  Those factors are a focus on the investment return after taxes, inflation and investment expenses. 

A brief example will highlight the factors that reduce an investor’s real return.  Many investors flocked to CD’s during the stock market’s decline in March of 2009.  I understand their concern for safety after watching the stock market plummet 50% from its highs.  However, an investor should consider the impact on real return (after taxes, inflation and expenses) of such a move.  Assume that an investor with a marginal income tax rate of approximately 30% moves $100,000 into a CD earning 3%.  Therefore, the investor expects to earn $3,000 of interest income and will be required to pay $900 ($3,000 x 30%) in income tax resulting in a real return of $2,100 after one year. 

Now let’s assume that instead of purchasing the CD that the investor places the $100,000 into several blue-chip stocks with an average dividend yield of 3%.  Unlike interest income that is taxed at ordinary income tax rates, dividends are taxed at the reduced capital gains tax rate that does not exceed 15%.  In this example, instead of paying $900 of income tax the tax bite is only $450 (15% x $3,000).  The investor also has the opportunity to participate in the market appreciation of the stocks purchased which has been significant since March 2009 (currently the S&P 500 is up over 50% from the March 2009 lows). 

I am not suggesting that everyone purchase dividend yielding stocks instead of CD’s.  I am suggesting that investors will be employ different strategies if they properly consider their real return after taxes, expenses and the impact of inflation.

There is always a trendy trading strategy that will attract attention.  However, most are just fads that will pass with time and be replaced with the next “great” investment gimmick.  There are an infinite number of ways to reduce taxes, expenses and the impact of inflation which can all improve an investor’s real return.  I believe that we should focus on the real and not the fad in order to generate real financial security.

Posted by Ron on 10/16 at 10:25 PM
Investment Tax Planning