Convert your traditional IRA to a Roth IRA
Is converting right for you?
In 2010 investors have an opportunity to convert their traditional IRA to a Roth IRA with special tax privileges. Beginning in 2010 there is no limit on a tax filer’s income that prohibits the conversion. (Pryor to 2010 the limit had been an income of $100,000.) In 2010 investors can convert their IRA into a Roth IRA regardless of income and have the choice of paying tax on the income in 2010 or spreading the tax fifty-fifty in 2011 and 2012. An investor has until October 15 of the following year (in this case 2011 to undo the conversion). This creates a unique opportunity for investors.
Inside of a Roth IRA an investor will not have to pay income taxes on the money when withdrawn from the account in accordance within the Internal Revenue Service rules. With a Traditional IRA the investor must pay taxes on the money when the funds are withdrawn. The Roth has more liberal withdrawal rules. The question you as an investor need to ask yourself is do you want to pay taxes now or when you withdraw the money?
Convert or not to convert?
Questions to ask yourself
The first question to ask is will my tax rates be higher now or in retirement. While no one has a crystal ball if you are living in California at this time and are paying 9.3 percent state tax and are paying 28 percent federal tax and are planning to move to a non income tax state and live modestly in retirement you probably would be better served by the traditional IRA and pay the taxes in retirement.
Conversely if you live in a low income tax state such as Michigan and plan to stay there when you retire you may look at things a little differently. You may feel income tax rates are going up at both the federal and state taxes are going to go sky high and you may be better served by paying the taxes at this time by converting to a Roth IRA.
Perhaps you know that you will be laid off for a few months this year or for other reasons will be in a one time lower tax bracket. Perhaps that time may be the time to convert.
There are calculators on the web. Most of the calculators will tell you that the more years you have until retirement the more favorable the Roth IRA is. The problem with these calculators is that they make assumptions which may or may not be true. There are more liberal withdrawal rules for home buying and education in a Roth which may be a consideration.
Personally I see higher income tax rates as a possibility both at the local and state level. Politicians are afraid of raising income tax rates and may chose alternative taxes such as sales taxes making a Roth conversion less desirable. We do not know what the future holds. I think a blend of Roth and Traditional IRA savings is a good approach.
When to convert an IRA to a Roth
I am a big believer in converting when the market is down. I converted an amount of money in March 2003 and March 2009. Why did I do this? When the market is down your IRA is worth less and I had to pay fewer tax dollars on the conversion.
Let us assume in March of 2009 you converted 5,000 dollars and the fund has doubled since then as many have, your investment is worth 10,000 and the taxes are paid on the money. You only paid taxes on 5,000 dollars. Don’t expect anyone to send you an e mail telling you the market has bottomed but if you are converting do it when the market is down. The stock market has ups and downs over the last 100 years or so and I expect that to happen again.
To convert an IRA from a traditional to a Roth contact your institution. Many times this conversion can be handled on line or over the telephone. You will have a few choices to make such as how much are you going to convert and how are you going to handle the tax aspect. I would not have taxes withdrawn from my IRA account as you will have to pay a penalty on that amount if you are under the age of 59 and ½. A better option in my opinion is to have you employer withhold more tax monies over the course of the year and pay the taxes gradually. The taxes on 5000 dollars might be 1250 which would be less than 25 dollars per week.
If you do not have an IRA at this time I would encourage you to open an IRA account.
When you invest do so wisely. Configure a good asset allocation Invest in the very best mutual funds, Small cap funds,, best mid cap, large cap, International funds, Bond funds and even concentrated funds you have available in your 401K.
You will always need to look at your income from year to year to determine if converting is right for you.