It’s the big sale that generated one big yawn.
It’s a one-time-only deal: Investors can take four years to spread the tax burden from converting a regular Individual Retirement Account into a Roth IRA, if and only if they beat the Dec. 31 deadline set by Congress.
If you shift accounts after this year, you’re looking at paying in one year all the taxes owed from converting to a Roth.
The yawn: Only a tiny group of IRA owners seems willing to budge, according to experts at three of the biggest players in the business.
“At the end of the day, I think it’s a relatively tough decision to do this and say, `Yeah, I’ll increase my tax bill,’ ” said Steven Mitchell, senior vice president for Fidelity Investments in Boston.
At T. Rowe Price Investment Services, another major mutual fund company, roughly 2 percent of the company’s $15 billion IRA assets have been converted to a Roth IRA so far.
Who qualifies? To be certain, not everyone can convert to a Roth IRA. Your taxable income, or adjusted gross income, must be $100,000 or less. The $100,000 limit applies to single taxpayers and married couples filing a joint return.
You cannot convert a regular IRA into a Roth IRA if you’re married and filing separately.
Even so, some people are sleeping through a good bargain simply because they don’t understand the Roth IRA, the special 1998 tax break or how to weigh their options.
Before the Dec. 31 deadline hits, we offer some answers.
Q–Who would want to pay extra taxes to convert to a Roth?
A–“The younger you are, the more sense it makes,” said Marilyn Capelli Dimitroff, president of Capelli Financial Services Inc. in Bloomfield Hills, Mich.
The younger you are, the more time you have to let your money sit in a Roth IRA and grow on a tax-free basis if certain conditions are met.
For example, you can withdraw the money tax-free from a Roth IRA if you have had money in the Roth account for at least five years and you are age 59 1/2 or if you meet the five-year requirement and are using the money to buy your first home.
Not so with a regular IRA. With a regular IRA, money taken out may be taxed in the end.
Eric Wade, who is 31 and single, figured he could save thousands of tax dollars by converting.
A few months ago, Wade rolled over $52,000 from an old 401(k) plan–money that had sat in a plan with a former employer–into a regular IRA. Wade then converted the regular IRA into a Roth IRA. Wade’s federal tax bill will be about $3,500 higher next April because he converted from a regular IRA to a Roth IRA.
And he’ll likely pay an extra $3,500 in federal taxes when he files his 1999 return, his 2000 return and his 2001 return. Altogether, he’s looking at about $14,000 up-front in federal taxes. That’s assuming he remains in the 28 percent tax bracket each year. If his income pushes him into the 31 percent tax bracket for a year or two, the tax bill would be higher.
But Wade, a financial adviser at the Center for Financial Planning in Southfield, Mich., estimates he could save more than $100,000 in federal taxes when he retires in 30 or more years and taps into his IRA. He figures that his $52,000–with an average 8 percent annual return–ultimately could grow to $448,000.
If that $448,000 were in a regular IRA, Wade calculates, he’d pay more than $125,000 in federal taxes when he withdrew the money. That’s assuming he’s in a 28 percent income tax bracket during retirement.
He says he’d rather pay $14,000 in taxes over the next few years to save more than $100,000 later.
“When I heard about the Roth option, it was too good to pass up,” he said.
Q–Does it ever make sense for someone 60 or older to convert?
A–In a few cases, it does.
The best candidate is someone who knows he or she will never need to tap into that IRA money, said Kenneth Klegon, a financial planner at Financial Management Associates in Okemos, Mich.
The Roth IRA does not require you to withdraw the money at any age. So you can just let it sit there and build. The regular IRA requires you start withdrawing some money in the year after you turn 70 1/2 years old, even if you don’t need the money.
Both IRAs could be subject to estate taxes. But heirs might not have to pay income taxes on withdrawals from a Roth if the money has been in the Roth for five years or more.
Another point to consider is that, if you receive Social Security benefits, check with your tax adviser before converting to a Roth IRA. The higher reportable taxable income could make some of your Social Security benefits taxable.
Q–How do you figure out how much it would cost you to convert?
A–Assume you had $50,000 in a regular IRA and you want to convert the entire amount into a Roth IRA.
And assume you received a $2,000 tax deduction each year you made a contribution to that regular IRA.
In this case, you’d owe taxes on the entire $50,000 of added income, said Patricia Bojanic, partner in charge of the tax department at Gordon & Co. in Troy, Mich.
How much? It depends.
If you convert the entire $50,000 in the regular IRA into a Roth in 1998, you can take advantage of a one-time-only deal. By converting this year, you have the option of spreading the extra income from the conversion over your 1998, 1999, 2000 and 2001 tax returns.
The $50,000 conversion would add $12,500 in income to each year’s return. So you’d pay an extra $1,875 in federal taxes each year, if you’re in the 15 percent tax bracket in each of the four years.
The tax jumps to $3,500 each year, if you’re in the 28 percent tax bracket in each of the four years.
Q–But what if you didn’t receive a tax deduction on your original IRA contributions?
A–You’d have to figure out how much of that $50,000 could be attributed to your original IRA contributions and how much is based on earnings.
If you put aside $2,000 each year for eight years and did not receive any tax deductions, your original IRA contributions would add up to $16,000. And your earnings would be $34,000. In this example, you’d owe taxes on the $34,000.
Q–How do I figure out how much money I could save by converting to a Roth IRA?
A–All sorts of Web sites–including www.rothira.com–offer calculators to try to figure out whether converting is a good move for you.
But the one huge drawback of these calculators is that all of them are based on making certain assumptions that really are wild guesses.
“Tell me what the tax rates are going to be in the year 2028,” said Nicholas Kaster, author of “Roth IRAs After 1998 Tax Law Changes,” ($59, CCH Inc., 800-248-3248,). Who knows?
But if you’re young, you need to guess the tax rates in 30 years to estimate how much money you’d end up paying in taxes if you withdraw money from a regular IRA.
You also need to guess when you’ll need the money. You could end up tapping into that IRA a lot quicker than you expect if your health or finances fail you.
Q–Who should forget about converting?
A–People who are a few years away from retirement who think they’ll use the IRA money soon and figure they’ll be in a lower tax bracket at retirement than now. Or people who don’t have the money outside an IRA to pay the higher tax bills. If you’re younger than 59 1/2, for example, you’d pay another 10 percent penalty for withdrawing money from a regular IRA to use to pay the taxes, Klegon, the Okemos planner notes.
Q–What if you convert to a Roth and then the stock market tumbles?
A–Convert again. The Internal Revenue Service will allow you to recharacterize your Roth IRA–convert to a Roth, convert back to a regular IRA and then convert to a Roth again–one time between Nov. 1 and Dec. 31. (Anyone who reconverted before Nov. 1 could have made the switch several times.)
Q–Do I have to convert by Dec. 31?
A–No. You have to meet the Dec. 31 deadline only if you want to spread the income over the next four years. Otherwise, you can convert in any year, but you are subject to the one-year tax hit.
One resource for taxpayers is the Web site www.rothira.com. This site rates a variety of IRA calculators.
Several mutual fund companies offer individual retirement account calculators at their Web sites, including the Fidelity Investments IRA Evaluator, www.fidelity.com; The Vanguard Group’s retirement calculator, www.vanguard.com.
