Taylor&Williams - personal wealth advisor

What a great time of year December is.  Not only do we get to celebrate Christmas and God's gift to us of himself, we get to embody some of that and give to others, especially those most precious to us.  We at Taylor & Williams hope that your Christmas season is memorable.  Almost as exciting is the chance to wrap the year financially and start to plan ahead for next.  OK, maybe not quite that exciting.

Never the less, 2010 provides a unique opportunity for the Roth IRA - The Roth IRA Conversion.

 

ROTH AND TRADITIONAL IRA DEFINED:

As a quick foundation, let me differentiate the Roth IRA from a Traditional IRA.  The Traditional IRA (401K, 403B, Simple, SEP and some others) allow contributions made within the limits of each to be deducted in the tax year made for income tax purposes.  The contributions plus interest or gain continue tax deferred until taken out of the IRA.  When taken out, the amount is considered taxable income in the year it is withdrawn. 

A Roth IRA works a bit differently.  The contribution is not deducted from income tax, so the contributions are made with after-tax dollars.  However, if held until the later of 59.5 years of age or 5 years, all monies taken from the account are tax free.  The contributions were already taxed, so all the interest and gain would be tax free income. 

For example, a $5000 contribution to a Traditional IRA would reduce taxable income this year by $5000.  Let's say that in 5 years, that grows to $10,000.  No tax would have been paid yet on any of the $10,000.  If all taken out at that time, $10,000 of taxable income would be included that year.

In a Roth, a $5000 contribution would not reduce taxable income this year.  But in 5 years, the $10,000 could be taken out without any of it taxable, thus earning $5000 income tax free.  (in both examples, some qualifications are assumed)

 

2010 ROTH CONVERSION:

Since the Roth IRA was created, converting a Traditional IRA to a Roth has been allowed.  The amount converted is realized as taxable income in the year of the conversion.  From that point on, the benefits of the Roth would apply.  However, in order to do this, Adjusted Gross Income (AGI) had to be less then $100,000.  This limit has kept many from being able to make the conversion.  In 2010, that limit goes away for just this one year.  In 2010, anyone can convert, pay the income tax, and enjoy the tax free growth of the Roth going forward.

In addition to removing the AGI limit, the conversion income is allowed to be split 50/50 between 2011 and 2012 income tax returns, thus allowing the tax payment to be put off for 1 and 2 years.

 

RULES OF THUMB TO CONSIDER:

- The Traditional versus Roth decision usually comes down to your income tax rate now versus in later years when you would be taking the money out.  If your tax rate will be lower in the future, then the Traditional IRA would most likely be best.  If your tax rate would be higher then the Roth would have the advantage.  (Of course it can be difficult to know for sure what our government will do in the future and what those tax rates will be.)

-  If money must be taken from the account to pay the taxes created by the conversion, it is probably best not to convert.

- Converting when the account value is the lowest creates the smallest taxable income, so converting early in the year (assuming growth during the year) would be best.

- Rules of thumb do not apply to everyone, so if you think this is something you may be interested in, give us a call.  We would love to talk it over.

 

END OF 2009:

Just a few days left in the year.  If you are still considering any capital gain / loss strategies, taking taxable income from an IRA, gifting of securities, etc., please let us know ASAP.  We are always happy to talk over with you or even work with your CPA to make sure that we are helping you be as tax smart as possible.

Thanks and Merry Christmas!