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Do This Only if You Trust the Government
09/14/2009 12:01 am EST
If you have money in an individual retirement account, or IRA Rollover account, you’re about to be faced with a big financial decision. But your answer will depend less on mathematical formulas than on your basic beliefs about the future.
So let me start by asking you two questions—and feel free to post your responses on my blog.
1. Do you think personal income tax rates will be higher or lower over the next ten, 15, 20 years?
2. Do you think the government will keep its promise to allow tax-free withdrawals from Roth IRAs over the next ten, 15, or 20 years? (Can’t wait to see your comments on that question!)
The reason your answers are so important is that starting in 2010 anyone—not just those who have income under $100,000 a year—will be able to convert a traditional IRA to a Roth IRA.
There’s just one catch: You have to pay income taxes on the amount you convert to the Roth.
Remember, your IRA or IRA rollover is likely to be filled with contributions that were deducted from your income when you made them, and gains (you still have gains?) that grew tax-deferred over the years. Contributions to a Roth IRA are not tax-deductible when they’re made, but all withdrawals can be made tax-free.
If you do the conversion from a traditional IRA to a Roth IRA in 2010, you can recognize all that income in the same year (2010)—or split it equally between the next two tax years (2011 and 2012). Either way, it’s going to be a huge tax bite for a lot of people.
And that brings me back to the two questions at the start of this posting.
I won’t be surprised if you think tax rates are moving higher. That’s why it might be tempting to do the conversion next year—unless top personal tax rates are increased between now and then. Remember, when John F. Kennedy became president, the top personal tax rate was 91%! (That’s not a typo!!)
But what better things might you have done with that money you’re sending to the government to pay the conversion tax? (For details on the pros and cons of conversion, go to www.schwab.com/roth.)
By the way, don’t take the money out of your IRA to pay the tax bill—or you’ll lose the best part of that benefit—future tax-deferred growth. And definitely don’t do it if you’re under 59-1/2 or it will be treated as a penalty withdrawal!
And, what if the government breaks its promise to make future Roth withdrawals tax free?
That’s not unprecedented. Ask seniors who counted on receiving tax-free income from municipal bonds how they feel about having that income added back to their “modified adjusted gross income” to determine how much of their Social Security check is subject to taxes! Or ask seniors with higher incomes how they feel about paying twice the Medicare premiums—even though high earners paid more in Medicare taxes over the years.
As you mull over this decision, these nagging worries may make you think twice about doing that Roth conversion. Future tax-free withdrawals (made at least five years after conversion) are tempting. But writing a huge check to the government next year might be even more painful than those long-term promised benefits.
One possible solution: hedge your bets by converting just a portion of your IRA to a Roth. That way, you won’t look back with complete regret about any decision you made.
What do you think? Are you ready to bet your own money the government will live up to its promises? Please join the conversation and have your say.
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