If the Wizard of Oz thrilled you as a child, then perhaps nothing better instills that sense of innocence, fear, and deliverance as an adult better than the IRS. After all, what could invigorate a taxpayer more than the thought of peeking behind the curtain to discover a new way to minimize your taxes? In 2010, the yellow brick road is the Roth IRA conversion that takes advantage of two IRS provisions that are limited to this year. But the flying monkey soldiers in this story aren’t IRS agents, they are the bankers, insurance agents, and stock brokers that would have you convert in order to close a sale rather than help you realize your retirement dreams.
First the Facts
Two things have changed for 2010. Where before you could not convert if your income exceeded $100,000, that limit has been eliminated. More importantly, the typical Roth IRA conversion generates taxes due in the year of conversion. For 2010 only, the tax due from conversion can be delayed, and split between tax years 2011 and 2012. So the tax man [still] cometh, he’ll just be late for dinner, but his appetite will be undiminished.
To Convert or Not to Convert
But before you head off to Emerald City, ask yourself this, When do you want to pay tax on your accumulated retirement money? The answer should be, When my tax bracket is lowest.
First, take a look at your tax return for 2009 once you’ve filed it, and determine your “marginal tax bracket”, your personal top tax rate. Then think about what your income will be in the future, specifically, in retirement. Short answer, if your tax rate will go up in the future, it may be worth converting; if you’ll be in the same or a lower tax bracket, it’s likely not worth it.
There are plenty of flying monkey soldiers in those trees, so here are some things you should watch out for if you’re being approached to convert.
“My advisor says that if I convert, I can leave my IRA to my kids tax free.” That may indeed be the result, but consider that if your heirs will be in a lower tax bracket than you, converting could mean a bigger tax bill. Bottom line, paying now doesn’t mean paying less when it comes to taxes.
“My insurance agent recommended converting an old 401(k) to a Roth IRA using an annuity that will give me guaranteed income in retirement.” Understand that converting has nothing to do in itself with what types of investments you choose. Given that 401(k) plans can have very low expenses, and that some annuities have recurring annual expenses approaching 4%, you should be wary of conversion as justification to alter your investment strategy. This is a classic bait and switch where a good strategy and a bad product do not a happy investor make.
“Someone at my bank suggested converting my IRA to a Roth, but I was concerned that I wouldn’t have the money to pay the extra taxes in 2011 and 2012. They said not to worry, that I could take a loan on my 401(k) or get a home equity loan to make up the difference.” Not having a ready source of funds to pay taxes is perhaps the biggest obstacle to conversion. Three things you should avoid altogether in coming up with the money to pay taxes on conversion are depleting your cash reserve or emergency fund, taking any sort of loan, and/or taking a distribution from the retirement account, which may incur early withdrawal penalties. Bottom line, if you don’t have a liquid source of capital to pay the taxes, converting is probably not right for you.
If you’re still whistling down the road to Emerald City, you should be able to answer yes to all of the following questions.
Is it probable that this will reduce the overall tax I’ll pay on my retirement savings?
Do I have enough money outside my retirement accounts to pay the tax?
Does converting make sense given my specific financial goals?
Here’s a final tip, when you peak behind that curtain, there shouldn’t be a wizard, there should be an accountant, and he or she should make sure that the IRS building falling out of the sky has a parachute on it and no bull’s eye on you.