Most high income Americans have an IRA, Individual Retirement Account, of some kind. The majority of those with IRAs have traditional IRAs in the form of a certificate of deposit, mutual fund, or 401(k). A traditional IRA defers income tax payments until the money is withdrawn years later by whoever holds the account. It could be the original investor, a relative, or even a family friend. Regardless of who ends up cashing in the IRA, he or she will have to pay income taxes the moment the money is withdrawn.
Roth versus Traditional IRA
Roth IRAs are the same as traditional IRAs with one major difference. The taxes are paid when you first put the money into the account. You pay a tax percentage based on your income and then the money will accumulate in the account until someone decides to withdraw the money. No taxes are paid when money is withdrawn for a Roth IRA account because the taxes were already collected on the original sum.
A Roth IRA account is better for the long-term investment. In a traditional IRA, the more you accumulate the more you will have to pay later in taxes. In addition, the more taxes increase while your IRA is sitting around, the more money will be required from the account when it comes time to collect. With a Roth IRA, you pay the taxes ahead of time so the money accumulated in the account is not affected. Essentially a Roth IRA account makes more money because in the end you pay hundreds or even thousands less in taxes. Most people choose not to get a Roth IRA account because they cannot afford the large lump sum of income taxes due when the money is deposited.
Gift of the Unlimited MAGI
Right now is a special time for those with traditional IRAs. Anyone with a traditional IRA can now choose to convert from his or her current IRA to a Roth IRA and split the tax payments between 2011 and 2012 instead of having to pay it all at once. Additionally, the MAGI, Modified Adjusted Gross Income, limits that usually stop anyone with a MAGI above $100,000 from being allowed to transfer from a traditional IRA to a Roth IRA are not currently in effect. This means anyone with any income level can transfer their traditional IRA into a Roth IRA account and take advantage of this limited time offer to split the tax payments between the next two years.
You do not have to split the payments if you do not want to either. You can choose to pay the 2010 income tax rate for your tax bracket. The reason you may wish to go ahead and pay the taxes now is that you do not know what the taxes may raise to in 2011 and 2012. Tax rates and tax brackets are not set in stone. You run the risk of paying a lot more in two more years than if you were to pay it all right now.
Don’t Worry, You’ve Got Time
The good news is that you do not have to make this choice until April 15, 2011. If you obtain a tax filing extension that date could even get pushed back even further until October 16. You still would have to convert before the end of 2010, but you do not have to worry about your tax payments for at least another three months.
However, just because you can convert does not mean you should. If you can’t afford the tax payments and aren’t sure if you could afford the taxes later on then you probably do not even need to consider transferring to a Roth account. This deal could still be in effect for the rest of next year as well.
That Doesn't Mean Time is On Your Side
Congress repealed the Roth conversion limits on January 1, 2010. While they are expected to do so, there is no guarantee that Congress will bring the limits back in 2011. Still, there are plenty of ways to reduce your MAGI score should the limits come back into effect.
The truth is no one knows what the people on Capitol Hill are going to do. Acting now may not be in your best interest. The best thing you can do is meet with a financial advisor and explore all your options. Do what will save you the most money.
Fletcher Martin is an Internet copywriter and blogger for various publications and his own blog. Read more of his work at unbelievablywritten.com.