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Just Because You Can Doesn’t Mean You Should

Is It Time to Convert to a Roth?

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The income restriction that kept some people from converting to a Roth account disappeared on Jan. 1, 2010. Just because you can convert to a Roth, though, doesn’t mean you should. Sure, with a Roth you can take tax-free withdrawals of your contributions at any time and of your earnings with some time limitations. But there are a few things you’ll want to check out to decide whether it makes sense to pay taxes now to pull out money tax-free later.

Because you contribute after-tax dollars to a Roth account, whether an IRA, 401(k) or 403(b), you can withdraw from it tax-free as long as you’re at least 59 1/2 years young and your money has been in the account for at least five years. The price you pay is taxes on the money — both earnings and deductible contributions — you move from a traditional IRA to a Roth.

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The quick rule of thumb is to convert if you expect your tax rate to increase during retirement (see screen captures, above). You pay a lower tax rate on the money you convert now and avoid the higher rate on all your compounded earnings when you withdraw later.
In most cases, you shouldn’t convert to a Roth if you think you’re paying higher taxes now than you will in retirement, but other factors affect your decision. Fortunately, the Web has numerous Roth conversion calculators to help. CalcXML’s version (see screen capture, this page) is quick and easy.
Suppose, for example, you have $10,000 in an IRA today and forecast that you’ll have $20,000 in the future. Your tax rate in 2010 is 20 percent and you expect the rate to be 30 percent during retirement. In the table on page 8, when the retirement tax rate is 30 percent compared with a 2010 tax rate of 20 percent, you’ll end up with more money by converting to a Roth. That’s because you’d pay a 20 percent tax rate ($2,000) on a smaller account balance in 2010, instead of 30 percent ($6,000) on a higher balance later on.
One pesky detail to consider is whether you have the cash to pay the taxes on the converted funds. You’ll make more in the long run if you keep your retirement nest egg intact. If you’ve had your IRA awhile, your stash could be sizable, which creates a big tax bill to boot. If you convert in 2010, you can opt for some pain relief by reporting half the taxable income in 2011 and half in 2012. After 2010, the bill is due in a single tax year.
You could consider paying your tax bill with money from a taxable investment account. The earnings in the taxable account would be taxed — for example, an 8 percent return after taxes might be only 6 percent — whereas earnings in a Roth come out tax-free, so you enjoy the full investment return you earned.
Converting to a Roth account looks better the further you are from a withdrawal date. With a traditional IRA, you must make required minimum distributions whether you need the money or not. The money comes out and is taxed, as are all future earnings. Roths don’t have required minimum distributions during retirement, so you can leave money in them for as long as you’d like, letting earnings compound untaxed until you’re ready for a withdrawal. If you keep money in a Roth longer, you can withdraw more each year once you start.

Link of the Month

Some other rules kicked off this year. The U.S. Department of Housing and Urban Development now requires lenders and mortgage brokers to use a standardized good-faith-estimate form. HUD also issued a new companion HUD-1 settlement statement, which cross-references the corresponding lines on the GFE, letting you compare the estimated closing costs with the actual ones.

Lenders still have to send you a GFE within three days of receiving your mortgage application, but lots of other aspects have changed. The new form explains crucial loan terms in plain English and clearly shows closing costs so that you can understand the loans you’re being offered. Plus, HUD estimates the new form could save the average borrower almost $700 at closing.
Once borrowers receive a GFE, lenders have to stick close to their estimated origination charges. In fact, changing estimated closing costs requires such extreme situations as war, natural disaster or inaccurate information on your application about your creditworthiness or the property’s value. If the lender chooses services such as title insurance, the lender’s estimates can’t increase more than 10 percent.
The new GFE has features that make it easier to compare different loans, similar to comparing unit prices at the grocery store. On the third page, the trade-off table might compare two other loan options with the one on the GFE. One option is the same loan with lower settlement charges, if you’re short on cash for closing. The other is for a lower interest rate, which saves tons of interest in the long run but comes with higher settlement charges. The shopping chart offers a broader comparison so that you can compare up to four loans from different lenders.

Websites of Interest
CalcXML Roth calculator
HUD’s good-faith-estimate form (PDF)
HUD-1 settlement statement (PDF)

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