On January 1, 2010, nearly $1.4 trillion of retirement assets will immediately become eligible for conversion to Roth individual retirement accounts. Under the Tax Increase Prevention and Reconciliation Act of 2005, higher paid individuals will be able to take advantage of an opportunity once limited to taxpayers with an adjusted gross income less than $100,000. (See box.)
The time to start planning for this opportunity is now. Here are some factors to consider:
1. The current market provides a low cost conversion opportunity. The current market may give savvy investors a unique opportunity to gain tax efficiency. Retirement accounts generally grow tax deferred. The investor, or his/her heirs, will eventually have to pay taxes on the value of those accounts. The higher the account value, the more taxes owed. Since many investors have lost 30% to 50% of retirement account value in the last 18 months, now may be a perfect time to recognize the income tax liability.
What if the Roth IRA continues to lose value after conversion? Ask the IRS for a “do over.” A retirement account converted to a Roth IRA can be “recharacterized” back into a traditional IRA with no tax consequences.
In golfing terms, the taxpayer gets to “Take a Mulligan.” It’s relatively straightforward. A Roth IRA can be recharacterized back into a traditional IRA up to the tax filing deadline, plus extensions. So, if one converts a traditional IRA to a Roth IRA in January 2009, the investor will have up to October 15, 2010 to decide whether to take the “do-over.”
2. Hedge against increasing income tax rates. For those who believe income tax rates will eventually increase, now may be the perfect time to convert retirement assets to a Roth IRA.
For decades, the United States had a top marginal tax rate as high as 50%, 70% and 90%. In fact, the 5-year period of 1988-1992 was the only time in the past 50 years when the top marginal tax rate was less than today’s 35%. Considering the current budget deficits and bailout/stimulus costs, many believe income tax rate increases are inevitable. Those sharing that belief may wish to realize taxable income now and take advantage of today’s historically low income tax rates.
3. Gross up the retirement account value. When paying the Roth conversion tax liability, the taxpayer could use either assets from the IRA or outside of the IRA.