By Travis Flenniken
Correspondent
As the end of the year rapidly approaches, it's probably a good time to consider the most appropriate tax planning strategies. One strategy that could save you taxes in the future is to convert a traditional IRA or an old 401(k) to a Roth IRA. Roth IRAs are after-tax retirement accounts that grow tax-free and allow for tax-free distributions.
As long as you pay the tax before the funds go in the Roth account, there are no taxes when you take the distributions on the principle or the gains. In addition, there is no requirement for Roth account holders to start taking required minimum distributions at age 701/2, unlike traditional IRAs.
Converting a traditional IRA to a Roth IRA means that you must pay taxes on the amount as ordinary income, which makes many investors less inclined to take action. It's always easier to do nothing than to take action, and it's much easier to pay taxes later rather than sooner; however, the traditional rules for Roth IRAs have
been modified in 2010, so it may be worthwhile to consider a Roth conversion.
Beginning this year, Roth IRA conversion income limits have been lifted. Prior to 2010, individuals who earn over $100,000 were previously ineligible for a Roth conversion; however because of the change everyone is eligible regardless of income level. An additional benefit of converting this year is the ability to split the tax liability up and pay over the next two years. This opportunity to reduce the one-year tax burden and spread out the payments is only for 2010.
Another way to reduce your tax liability in a Roth conversion is to make a partial conversion. It is possible to convert less than the full amount of your IRA or 401(k) into the Roth.
By doing this, it limits your tax obligation only to the amount you convert and could prevent you from being bumped into a new tax bracket. With the uncertainty of future tax legislation, splitting up the traditional IRA could also be a sensible tax-hedging strategy.
If you're mulling a Roth conversion, don't assume the decision is as easy as determining if you will be in a higher tax bracket in the future; there is more to consider.
For example, if you don't have the cash to pay taxes at conversion, you will have to use some of the principal of the Roth to pay the taxes, and if you're under 591/2, you will pay a 10 percent penalty for early withdrawal. High-income households may also have to consider what effect the alternative minimum tax will have if they convert to a Roth. Also to be considered is the new Medicare surtax, which is a new 3.8% surtax on the lesser of net investment income or the excess of modified adjusted gross income over a certain threshold amount.
Roth conversions in 2010 could reduce exposure to the new surtax, and if you think Congress will end the year without extending the Bush-era tax cuts, it probably makes sense to convert now. There are also several factors to consider when making plans for estate taxes.
We recommend that you give your tax adviser a call and ask him or her if a Roth conversion makes sense for you in 2010.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken, CFA, is vice president of investments with DeMoss Capital - demosscapital.com. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at jvass@timesfreepress.com.