I was looking into my crystal ball yesterday, you know, the one that all financial planners have, and saw something interesting. It appears that the traditional belief that your taxes may be lower when you get older is not as concrete of an assumption that it may have been in the past.
The Traditional IRA has been one of the staples of saving for retirement since it was introduced in the Tax Reform Act (TRA) of 1986. The idea is pretty simple. Make contributions today, deduct them from your taxes (if your eligible), let them grow tax deferred, and pay the taxes upon distributions which need to start no later than age 70 ½. If you have one, then the next few paragraphs may be of interest to you.
As an alternative to the IRA, the Roth IRA was introduced in the Taxpayer Relief Act of 1997. In an admittedly gross over-simplification, think of the Roth as an upside down IRA. You get no deduction on money you contribute; only after-tax dollars can go in. The growth is still tax deferred, but upon withdrawal (which does not have to start at age 70 ½ or ever) there are no taxes due.
The argument, “which is better?” has long been debated in the financial planning community. Unless you are 100% correct on the assumptions you make, the answer can only be known in hindsight. In my opinion tax deferral during growth is a win either way.
So back to that crystal ball. While it’s never completely accurate, it seems pretty evident that starting next year, there’s a good possibility that your tax rates will be going up. Anytime we have better clarity of the future there is a great financial planning opportunity.
In 2010, laws were changed and the income limitations for converting your traditional IRA to a Roth IRA were lifted. Now that we know tax rates may be rising, the idea of converting can make a lot of sense.
Here’s a list of situations where converting before the end of the year may make sense:
- You don’t want to be forced, or never plan on taking withdrawals from you IRA. There are also tax advantages if you were to leave your Roth IRA funds as an inheritance.
- You believe tax rates will be higher tomorrow then they are today
- You want potential access to those funds before retirement. You can access your savings at any time if you’re 59½ or older with either plan. If you’re younger, after waiting 5 years you can access your principal (conversion amount) without a penalty.
- You could potentially avoid taxation on your Social Security Benefits. Up to 85% of your Social Security retirement benefits could be taxed depending on your income. Mandatory traditional IRA distributions count as income.
Here are some things to keep in mind if you do want to convert:
- You have to pay taxes on your conversion. All those taxes you deferred, well it’s time to settle up with Uncle Sam. The advantage as discussed above is that the slate is now clean and from here on out, no more taxes
- If you’re under 59½, don’t expect to take that money for taxes out of your new Roth. You can, but you’ll be subject to a penalty. It would be best to pay that tax bill from outside resources. (Which may make sense even if you’re over 59½ )
My suggestion, speak with your Financial Advisor or accountant. They will provide a more thorough explanation of the rules involved and have access to calculators that will help make the decision clearer for you. Remember, there are no magic bullets, only proper planning.
Noah is a Certified Financial Planner ™ and writes on Patch for the promotion of financial literacy and awareness -- a topic in which he believes an informational void exists. He makes himself available by appointment, telephone, or email to all readers and can be reached at 203-204-6226 or firstname.lastname@example.org
Noah Schwartz is a Registered Representative and Investment Advisor Representative of and offers securities and advisory services through WRP Investments, Inc., member FINRA & SIPC. Blueprint Financial Strategies is not affiliated with WRP Investments, Inc. Securities and advisory services are supervised by WRP Investments, Inc. at 4407 Belmont Avenue, Youngstown, OH 44505 (330) 759-2023.