Suppose your rich great uncle left you a large inheritance, but you had to choose between receiving $1,000,000 or $850,000. You're no dummy; you would go for the cool million!
Let's make this scenario a little more interesting. Suppose the $1,000,000 is fully taxable as ordinary income, but the $850,000 is completely tax-free. Now, which would you choose? Obviously $850,000 tax-free would be worth far more than $1,000,000 after taxes. Depending on the state you live in, you could easily see the $1,000,000 reduced by 40 percent, leaving you with $600,000.
Trillions of our nation's wealth is tied up in accounts like the $1,000,000 above, specifically in IRAs and other tax-deferred retirement plans like 401(k)s, 403(b)s, TSPs, TSAs, PSPs, and Deferred Comp plans, to name just a few. The dangerous term here is tax-deferred.
For decades you've religiously contributed to your retirement plan and received an income tax deduction. You've had a plan for accumulating money into your retirement plan, but what's your plan for when the money comes out? If you don't have a plan, the IRS does.
In essence, the IRS has a mortgage on your tax-deferred retirement accounts because you have to pay them off before you get anything! It's inevitable that at some point, this great passage of wealth will be taxed, so the question becomes would you rather pay tax now (while tax rates are low) or later (when tax rates are higher)? In other words, with taxes set to skyrocket in a matter of months, Roth conversions are far more attractive than what they will be in the coming years.
That's the beauty of a Roth conversion; you can lock in today's low tax rates on all or a portion of your tax-deferred retirement accounts. Let me be more specific: Turn forever taxed into never taxed! Pay off the IRS mortgage now and position your retirement and the legacy you leave behind to grow tax-free. Remember the previous rich great uncle example? The $850,000 tax-free is far more valuable than $1,000,000 taxable.
With tax rates at historic lows over the next few months, there's a unique opportunity to convert your tax-deferred retirement account into a tax-free retirement account: the Roth IRA. Some say older retirees shouldn't consider converting to Roth. I say that's hogwash. If you're not planning on using your IRAs, but rather planning to pass them to family, it may be valuable to start converting to Roth now while tax rates are in the clearance bin.
Are Roth conversions the best thing since sliced bread and pop-rocks? Hardly. Roth conversions are not for everyone; there are just as many reasons why you shouldn't convert as there are reasons why you should.
Why you SHOULDN'T convert to Roth
--If you need access to the money within the next five years
--If you don't have funds outside the IRA to pay the taxes on the conversion
--If you plan to leave your IRAs to charities
--If you are using IRA distributions to fund a life insurance policy to leave a larger tax-free inheritance
Why you SHOULD convert to Roth
--If you want to take advantage of low tax rates and remove uncertainty about future tax rates
--If you want to leave a tax-free legacy for your spouse, your kids, and your grandkids
--If you want control on when you take withdrawals (no required distributions at age 70 1/2)
While there are differing camps on this debate, I believe the number-one reason why you should not do a Roth conversion is if you do not have funds outside the IRA to pay the income tax on the conversion. The last thing you want to do is to withhold taxes from the IRA in order to convert to a Roth, thus reducing the value of your Roth.
For example, if you want to convert $100,000 of your IRA and you withhold 25 percent for taxes, your "new" Roth is only worth $75,000. It will take years to gain back the "lost" $25,000. Instead of withholding taxes, look for possible sources to pay the conversion tax, including bank accounts and CDs (lazy money) or brokerage accounts (stocks and funds).
Robert Russell is CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and is a frequent contributor to FOX Business and CNBC.
Securities offered through Kalos Capital, Inc., Member FINRA, SIPC. Investment Advisory Services offered through Kalos Management, Inc., 3780 Mansell Rd. Suite 150, Alpharetta, GA 30022, (678) 356-1100.
Russell & Company is not an affiliate or subsidiary of Kalos Capital, Inc. or Kalos Management, Inc.
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