Converting IRAs to Roths
April 16, 2010, By Josh Katzowitz 7 comments
No matter how hard you think about a way around it, you’re going to be taxed for all the money you’re making in investments. Somehow, some way, the taxman is going to knock on your door.
Your stocks go through the roof, allowing you to put an actual new roof on your house? You’ll pay taxes on the gains. You’re pulling down 3 percent from your safer-than-Sid-Bream-at-home-plate Certificate of Deposit? You’ll pay taxes on your small return. You make pennies of interest in your savings account that, if you’re lucky, affords you 1 percent? You’ll pay taxes.
We know this, of course. We also know that, as we grow older and spend more of our time thinking about how best to use the system to leave us paying less money on April 15, we want to be taxed on investments as little as possible.
That’s why you should be putting your after-tax money in an investment that will grow your money tax-free. That’s why you should be devoted to Roth IRAs (Individual Retirement Account).
“Roth IRAs are the best thing since sliced bread, just because of the tax implications,” said financial advisor Byron Larkin, who counts a number of current and former professional athletes among his clients. “It’s about what pile of money do you want to pay taxes on?”
Think about it that way and the answer becomes quite clear. To illustrate, Larkin makes an imaginary graph with his hands.
Here’s the image of a traditional IRA, he says. You use pre-tax money – perhaps you’ve rolled over a 401(k) into an IRA – and as your investment grows, so does your tax liability. You’ve started down here, Larkin says, nodding toward his left hand which sits on the table in front of him. When you retire and receive your IRA gains, he looks to his right hand, which is held high above his head. That right hand is the money you’ve made but also the money you’ll have to pay in taxes.
We start over. In a Roth, which was established in 1997, the taxes are paid before they’re ever invested. That’s where his left hand rests on the table. Then, when you retire and take the Roth from his highly-held right hand, you don’t pay taxes. Your right hand is entirely tax free. It’s almost too good to be true.
A quick example: Say you put $5,000 into an IRA for 10 years. That’s $50,000, and over time, that amount will grow and will be paid out, if you so choose, after you turn 59 ½ years old. But that huge stack you’ve invested and the gains you make when you’re entering your 60s? That’s the amount on which you’ll pay taxes.
But say you put $5,000 after-tax dollars into a Roth for 10 years. That $50,000 also will grow and also will be paid out after you turn 59 1/2. But that huge stack of money, that huge nest egg for retirement? It’ll send the tax man slinking away.
“A lot of people don’t know how long the Roths are going to be around; that’s how good they are,” Larkin said. “Anybody who can do the Roth IRA should do it.”
Roth IRAs have gotten even better in 2010. In 2010 and 2010 only, you can convert your traditional IRA or your 401(k) into a Roth IRA and you’ll have two years to pay the taxes on the transfer. In fact, you won’t have to include the conversion on your income for 2010 at all and you can split the taxes between the 2011 and 2012 returns.
You also won’t have to pay the normal 10 percent early withdrawal penalty for taking the money out of your traditional IRA before the age of 59 1/2, and though there had been an income limit to qualify for a Roth – an adjusted gross income of more than $100,000 prevented you from opening a Roth – that has been repealed for 2010.
You’ll have to beware, though. That moving your money into a Roth could provide a quandary if your college-age student has financial aid, because the transfer will count as income for 2011 and 2012 if you split it that way. Plus, there’s no guarantee that the tax cuts implemented by the George W. Bush administration will be in effect after this year. Plus, you won’t receive any tax deductions for contributing to a Roth (you probably would for a Traditional).
For sure, the Roth isn’t right for every investor. But for many of us, it’s a pretty sweet deal. And because we can move our money from a Traditional IRA and a 401(k) into the Roth in 2010, that’s almost too good to believe.
“I would absolutely get into the Roth by any means necessary,” Larkin said.
“You have a short window where you can pay those taxes in just two years instead of one year, and I would highly, highly suggest everybody do that. No question about it, in long–term tax planning, it’s the best thing you can do.”
Josh Katzowitz lives in Atlanta and covers the NFL for CBSSports.com. He is a featured contributor to ManoftheHouse.com and author of the book, Bearcats Rising. He's currently working on a book about pro football that is scheduled to be released in 2012.
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