Switching to a Roth Makes Sense Now
Pay Uncle Sam upfront and get tax-free income in retirement.
OUR READERWHO: Mark Crossler, 46WHERE: Eugene, Ore.QUESTION: What's a good strategy for dealing with the likelihood that my tax bracket will go up?During his long commutes to work, Mark, a marketing professional from Eugene, Ore., likes to listen to personal-finance books on his iPod. His aha moment came when he realized that many of the tax breaks that he and his wife, Sandy, enjoy -- deductions for interest on their mortgage and home-equity loan; deductions for contributions to his 403(b) retirement plan; the $1,000-a-year federal tax credit for their son, Jacoby, 7; and the state income-tax deduction they get for contributions to Jacoby's 529 college-savings plan -- will disappear when they retire and pay off their mortgage. So even after they stop working and saving, they could still land in a high tax bracket.
And that bracket may be moving higher. As federal and state budget deficits grow, so do concerns that tax rates will rise. That makes moving money from a traditional IRA to a Roth look like a smart strategy. "Roth IRA conversions are the silver lining to the economic crisis," says IRA expert Ed Slott, a CPA in Rockville Centre, N.Y. "These may be the lowest tax rates you'll see for the rest of your life. And with account values down, it's a double sale."
Mark and Sandy started transferring money from traditional IRAs to Roth IRAs last fall after the stock market collapsed. Before the end of 2008, they also sold some investments they held in taxable accounts, locking in losses to offset future capital gains and generating cash to pay the taxes on the Roth IRA conversions. (If you use IRA funds to pay the tax, you'll incur additional tax and possibly pay a 10% early-withdrawal penalty.)
The Crosslers' $25,000 Roth conversion cost them an extra $5,700 in combined state and federal taxes in 2008, but they think it was worth it. "As the market rebounds, we'll have the added benefit of all that money growing tax-free for the rest of our lives," says Mark.
Wait till next year
To qualify for a Roth conversion in 2009, your adjusted gross income can't exceed $100,000, whether you are single or married. If your income is too high, be patient. Income limits on Roth IRA conversions disappear in 2010, so anyone can convert to a Roth IRA. Better yet, if you wait until then, you can spread the tax bill over two years, splitting it between your 2011 and 2012 tax returns.
Part of Mark's motivation is to have more control over taxes in retirement, when Roth withdrawals are tax-free. "We can withdraw enough taxable income from our traditional retirement accounts to keep us in a low tax bracket and then supplement our income from our Roth IRAs," says Mark.
That strategy makes sense, although the couple may not want to tap their Roth accounts quite so soon, says James Lange, head of James Lange and Associates, a financial-planning group in Pittsburgh, and author of Retire Secure (Wiley, $24.95). For instance, if you want to leave a legacy to your heirs, a Roth IRA trumps all other accounts, says Lange. There are no mandatory-distribution requirements, and your beneficiaries can inherit the account tax-free.