Changes in IRS provisions can affect IRA conversion decisions

Navigating the waters of IRAs can be a tricky proposition for taxpayers. Things have changed for the year 2010 in regard to IRAs, said Andy Oakes, financial adviser for LeConte Wealth Management. Consumers need to know the facts on Roth IRA conversions as they look at two Internal Revenue Service provisions that are limited to this year alone.

LeConte Wealth Management offers several tips for navigating these tricky IRA waters:

First the Facts:

Two things have changed for 2010. In previous years, if one’s income exceeded $100,000, a Roth IRA conversion was not an option. This limit has been eliminated. More importantly, the typical Roth IRA conversion generates taxes due in the year the conversion takes place. For 2010 only, however, the tax due from conversion can be delayed and split between tax years 2011 and 2012.

“These taxes must still be paid -- just at a later date,” said Oakes.

To Convert or Not to Convert:

It is important for consumers to ask themselves, “When do I want to pay tax on my accumulated retirement money?” According to Oakes, the correct answer should be, “When my tax bracket is lowest.”

First, take a look at your tax return for 2009 once it has been filed and determine your “marginal tax bracket,” also known as your personal top tax rate. Then, think about what your income will be in the future, specifically, in retirement. If your tax rate will go up in the future, it may be worth converting. If you will be in the same or a lower tax bracket, it is likely not worth converting.

“Consumers should be sure that their choices on converting or not benefit them, not someone else,” Oakes said.

Below are some commonly asked questions and red flags that LeConte Wealth Management encourages consumers to watch out for if approached to convert a Roth IRA:

1. “My adviser says that if I convert, I can leave my IRA to my kids tax-free.”

That may indeed be the result, but keep in mind that if your heirs will be in a lower tax bracket than you, converting could mean a bigger tax bill. Paying now does not always mean paying less when it comes to taxes.

2. “My insurance agent recommended converting an old 401(k) to a Roth IRA using an annuity that will give me guaranteed income in retirement.”

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 variable annuities have recurring annual expenses approaching 4 percent, 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.

3. “Someone at my bank suggested converting my IRA to a Roth IRA, 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 and 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 1) depleting your cash reserve or emergency fund, 2) taking any sort of loan, and / or 3) taking a distribution from the retirement account, which may incur early withdrawal penalties. If you do not have a liquid source of capital to pay the taxes, converting is probably not right for you.

Bottom Line:

You should be able to answer “yes” to all of the following questions:

1. Is it probable that a conversion will reduce the overall tax I will pay on my retirement savings?

2. Do I have enough money outside my retirement accounts to pay the tax?

3. Does converting make sense given my specific financial goals?

(LeConte Wealth Management provided the information for this story.)

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