IRA
Wall Street Has One Answer to Wealth Creation; Another is Tax Reduction
by Wayne Michael Lottinville, CFA (Write for us!)
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There are more ways to generate wealth than relying on what Wall Street has to offer. One
of the better alternatives, in fact, is to invest in reducing your taxes. You may have made $1 million in the market last year, but if your marginal tax rate is 35%, in an extreme case you could possibly be left with just $650,000. Even onerous investment commissions and fees can be significantly less than the bite of the tax assessor.
How, then, to reduce this bite? Here's a medicine that could be hard to swallow, but that could improve your future financial health and wealth.
Convert to a Roth IRA
Conversions to a Roth IRA are taxed today. But wait, weren't we going to reduce taxes? The beauty of the Roth IRA is that while you pay taxes on your conversion today, you can later make qualified withdrawals completely tax-free. Furthermore, now may be the best time to convert your non-Roth IRAs (such as a traditional IRA, SEP, or SIMPLE).
Yes, income taxes today are painful, but the fact is that they are lower now than at any time in recent history. With the federal deficit ballooning, trade imbalances threatening, and Baby Boomers soon making claims on Social
Security benefits, many analysts predict that tax increases are now much more likely than additional tax decreases - regardless of which party wins the White House.
If this is true, then it may make a lot of sense to convert your non-Roth IRAs into Roth IRAs today and-however painful-pay today's lower taxes. Think of it as a long-term investment where you pay taxes today for a return of no taxes in the future. Consult with your tax and financial advisors to determine if conversion makes sense for you and if you qualify. Here are a few questions to consider.
How long will it be before you withdraw the converted assets? The longer the better so that your converted assets will have a good change to grow. Ten years or more offers the greatest potential benefit.
Will your tax rate in retirement be the same as it is now or higher? If so, conversion makes a lot more sense. Again, many economists predict that tax rates must increase to pay our country's increasing debts.
Will conversion put you in a higher tax bracket in the year of conversion? If so, you may be able to avoid the increased marginal tax rate by doing a partial conversion this year and the remainder next year or later.
The Most Difficult Requirement
Will you be able to pay the additional taxes out of your taxable assets? This will be difficult for those already stretched thin, but you do not want to use converted IRA assets to pay the taxes due on the converted amounts. In addition, conversion
could trigger estimated quarterly taxes. Ouch!
Will rates of return on converted assets be high enough to compensate for the immediate tax liability? With a well-diversified portfolio and sensible asset allocation, you are likely to achieve a return in the next 10 to 20 years that more than compensates for the immediate tax liability. In fact, this is one of the better reasons for converting now.
Lastly, do you expect that your beneficiaries will inherit the converted assets? Regarding taxes, a Roth IRA may be easier on your heirs than a non-Roth IRA.
This is just a starting point. Check out Vanguard for a fairly simple preliminary calculator where you can get an idea of whether it makes sense for you to convert to a Roth IRA. Perhaps the easiest way to get there is go to Vanguard.com, then search for the phrase "should I convert." Again, if you decide that you might want to convert to a Roth IRA, check it out first with your tax and financial advisors.
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