The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) makes Roth IRA conversions available to all taxpayers, regardless of income.
Now, even high-income taxpayers can take advantage of Roth IRAs. This is a game-changer. TIPRA requires different thinking in the way clients approach retirement. So, here are three retirement planning maxims that merit re-evaluation in light of TIPRA:
Defer taxes whenever possible. Tax-deferral has been a pillar of financial planning and rightly so. In fact, other than tax-deferred retirement accounts and municipal bonds, there have been few alternatives for high-income taxpayers. Roth conversions change that.
Converting assets and paying taxes at today’s historically low rates is a way to diversify retirement account types while hedging against an uncertain tax environment in the future. The conversion of today’s reduced account balances will result in a lower tax liability while giving those assets the opportunity to recover in an income tax-free account. Coincidentally, tax-deferral remains an option on conversions done in 2010, as TIPRA allows conversion income to be spread evenly and taxed in years 2011 and 2012.
Tax liabilities will be lower in retirement. Given the depth of the fiscal crisis, it seems prudent to plan for an increase in income taxes. Rising state and local tax rates also seem inevitable. In addition, depleted retirement accounts will cause many to postpone retirement, work part-time or tap IRAs and 401(k) plans earlier than planned. The combined result will be more taxable income (subject to higher rates) than perhaps was originally anticipated.
Remember that Roth owners are not subject to required minimum distributions, and distributions from the Roth are generally income tax-free. Hence, having the foresight to suggest conversion of assets to a Roth IRA today could make a major difference for clients as they navigate a future retirement made more challenging by expected higher tax rates and the need to work longer.
Healthcare is the greatest expense in retirement. Certainly, healthcare is and will be a major retirement expenditure. But for those in the highest tax brackets, the greatest expense may very well be income taxes. This is compounded when people turn 70 1/2 and then face mandatory withdrawals from traditional IRAs and 401(k) plans. And with tax rates expected to rise, the percentage of retirement expenses represented by income taxes will grow larger.
As volatility and uncertainty buffet the best-laid retirement plans, conversion is a way to establish control in managing income taxes as a retirement expense.
The new rules don’t go into effect until 2010, but it’s not too early to develop a strategy to help clients make informed conversion decisions. Here are some ways to get started: