Retirement savers who have spent the month of May watching their portfolios steadily drop can look on the bright side, at least a little bit: Declining stock prices offer them an opportunity to convert their traditional Individual Retirement Accounts (IRAs) into Roth IRAs, without getting too beat up by the tax man.
There are special reasons to consider that conversion in 2010; we'll get to them in a minute. But first, the basics: A traditional IRA offers investors tax deductions for their initial contributions, but then taxes all withdrawals as regular income. So, if you put $5,000 into an IRA now, you'd get a tax deduction for the $5,000. At the 25 percent tax bracket, that would save you $1,250 in taxes, right now. After 20 years compounding at an average annual return of 8 percent, it would be worth $24,634 and that's the amount that would be taxable as you withdrew it in retirement.
Roth IRAs, in comparison, don't give you a deduction for your initial contribution. But all of the money that compounds within the account can be withdrawn tax-free in retirement. So you'd have to make that $5,000 deposit with after-tax income. But in 20 years, you'd have $24,634 to use without paying additional taxes.
Taxpayers who earn less than $100,000 are allowed to convert their traditional IRA into a Roth IRA by paying income taxes on the tax-deferred portion of the conversion. The theory behind that is that it's better to take your medicine (pay your taxes) now, than to wait until you retire, when tax rates may well be higher.
Now, what's so special about 2010? Just for one year, that $100,000 limit is removed, so anyone at any income level can convert if they want to. And another provision allows folks who convert in 2010 to spread the resulting increase to their taxable income over 2011 and 2012.
Should you convert? And if you do, should you take advantage of that spread-the-pain rule? Finally, what if you already converted at the beginning of the year, but regret it now? A few pointers.
-- The entire convert-or-not decision basically rests on whether you think your own personal income tax rates will be higher or lower in the future, when you are using the money. They could well be higher, if the Federal government decides to fix the deficit by raising income tax rates across the board.
Young retirees who must depend on sizable IRA withdrawals to keep up their lifestyle (say, continuing to pay on a mortgage), could also see their own post-retirement income high enough to trigger the same (or higher) tax rates as they are already paying. Couple those considerations with the stock market declines in the last month (which reduce the total amount you'd be converting and taxed on), and conversion in 2010 seems to make sense.
-- If you can't afford to pay the taxes on the conversion without liquidating part of your account (thus adding a 10 percent penalty to the tax bill) or borrowing them on a credit card, then don't convert.
-- Think carefully before spreading the tax burden into 2011 and 2012. The Bush tax cuts expire at the end of this year, and while President Obama has said he wants to preserve the rate cuts for families earning less than $250,000, that may not hold. Furthermore, other potential tax increases, such as limiting deductions for high earners, could hit you harder in 2011 and 2012 if you convert a big enough IRA to push you into higher tax brackets. One reason to wait: If the full amount of your conversion bumps you into a higher bracket in 2010, but splitting it into 2011 and 2012 would keep you in a lower expected bracket.
-- Can you unconvert? What if you converted your IRA into a Roth on May 6, when the Dow Jones Industrial Average hit its 2010 top of 11,151. This week it's barely above 9,800. That's a 12 percent decline, and if your IRA was fully invested in stocks you could have lost even more than that since then. You can reverse your conversion (called a recharacterization) until October 15 of next year. When the loss in value is significant... a recharacterization is in order, says financial adviser Robert Carlson in his newsletter, Bob Carlson's Retirement Watch. He tells clients to split their rollover Roth IRAs into several different accounts, based on the kinds of securities that are in them. That way, they can choose to selectively reverse the conversions of only the accounts that make sense.
-- Changed your mind again? You have one more opportunity, after converting and reversing that conversion to reconvert during the same year, as long as you wait 30 days. So you could undo your May 5 conversion now, but you'd have to wait until the end of June to put that money back into a Roth. By then, prices could even be higher and you'd regret the round trip.
(editing by Gunna Dickson)