Turn Panic into Tax Profits

Consider the tax advantages of doing a Roth IRA conversion right now.

Laura Adams, MBA
4-minute read
Episode #102


Today's topic is about a way to actually profit from the decline of the financial markets by converting a traditional IRA into a Roth account if you’re eligible.

Traditional vs. Roth IRAs

One of the major distinctions between a traditional and Roth IRA is that Roth accounts require you to invest after-tax money. You don’t get an upfront tax break like you do with a traditional IRA. But once taxes are initially paid you never have to pay tax on funds in a Roth account again. As long as you’ve had a Roth for at least five years, when you begin to take qualified distributions after the age of 59½, there is nothing to pay Uncle Sam. That’s a nice retirement gift!

See the Silver Lining

If you have a traditional IRA, chances are its value has decreased this year due to the volatile stock market. That’s actually good when it comes to converting it to a Roth. This is because you must pay income tax on any amount you convert that wasn’t previously taxed. How much tax you pay depends on your income tax bracket and the total amount that you’ll convert to a Roth.

Less Taxes are Always Better

You may be wondering, “Why would I want to take a tax hit now?” Well, the reality is that tax must be paid on that money eventually. If it remains in a traditional IRA, you are simply deferring taxes until the time you begin to take distributions in the future. But what if tax rates are lower now than they will be in the future? Or what if you’ll be in a higher tax bracket at retirement than you are now? In either of these situations, it could make sense to pay less in taxes now than to wait and pay more in the future.

Roth IRA Benefits & Restrictions

Besides the timing of taxation, another difference between traditional and Roth IRAs is what happens to the money once you reach age 70½. With traditional IRAs you must begin taking mandatory distributions from the account at this age. However, with Roths there are never mandatory distributions, no matter your age. This means you can contribute to the account past age 70½ and leave the money there until your death. This feature makes Roth IRAs a great vehicle for money that you want to pass on to your heirs.

These are a couple of the benefits that make Roth IRAs one of the most recommended retirement savings vehicles for those in the middle-class. The only restriction is that you can’t make too much money. You can not make over $100,000 for the tax year you decide to do a Roth conversion. And once you have the Roth in place your income cannot exceed annual limits set by the IRS and still make contributions. For 2008 this income limit is $169,000 if you’re married and file jointly. If you file taxes as a single person or head of household the income limit is $116,000.

Here’s a tip if you begin investing in a Roth IRA but find that later on your income exceeds the allowable limits. Simply leave the Roth in place to continue to grow, but open a new traditional IRA and begin investing in it instead.

Allowable IRA Contributions

The annual maximum amount that you can contribute to a traditional IRA, Roth IRA, or to both is limited by your taxable income, up to $5,000 for 2008. So if you’re a student and will only make $3,000 in 2008, for example, your IRA contributions cannot exceed $3,000. But if you’re at least 50 years of age by the end of 2008, you can contribute an additional $1,000 as a catch-up provision, for a maximum contribution of $6,000. And remember that you can make contributions to a traditional or Roth IRA up until April 15th following the tax year.

How to Convert to a Roth IRA

A Roth conversion is accomplished by doing a transfer or a rollover. With a transfer you direct your IRA trustee to move your funds by a certain date. If you do a rollover you receive the distribution check from the traditional IRA, and send it to the new Roth account. This must be done within 60 days or you’ll have to pay taxes plus an additional penalty for taking an early distribution. An IRA distribution is taxable in the year you receive it. So if you were to receive a distribution on the last day of 2008 and complete the rollover within 60 days by the end of February 2009, for example, the transaction would be taxable in 2008.

If you’re eligible to convert a traditional IRA into a Roth this year, consider the benefits as well as the immediate tax consequences. If you wait until the market begins to recover, you may miss out on the opportunity to get a big discount on your retirement tax bill.


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About the Author

Laura Adams, MBA

Laura Adams received an MBA from the University of Florida. She's an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura's previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.