IRA Conversion Tips and Traps

Description

Noted retirement planner Natalie Choate outlines four factors that favor conversion, plus pitfalls to avoid.

Transcript
IRA Conversion Tips and Traps Morningstar Retirement Focus with Christine Benz Christine Benz: Hi I’m Christine Benz for Morningstar. Here at the Investment News Retirement Income Summit. I’m happy to say that I’m joined today by Natalie Choate. Natalie is the Author of Life and Death Planning for Retirement Benefits and she’s also one of the 4 most retirement planning experts in the country. Natalie thank you so much for joining us. Natalie Choate: My pleasure Christine. Christine: So one interesting opportunity that has emerged for retirement planning this year is the lifting of conversion of income limits for IRA conversions and you’ve written a lot about this topic. You had a great piece on key tips and traps to avoid. So let’s start with the tips. Some things to think about and when you’re trying to determine whether you’re a good candidate for a conversion? Natalie: Alright I think everybody who has a plan or IRA is now wrestling with this should I convert to a Roth IRA and it’s a tough decision to make so I’m going to try to make a little bit easier by one tip which is that everybody who is in this room, everybody who is watching this should open a small Roth IRA now today if you haven’t done it already. Christine: Okay. Natalie: And the reason, there’s two reasons for that, one is that you’re going to get your 5 year clocks started by doing that. Roth IRAs are famous because they have tax free distributions but actually the distributions aren’t always automatically tax free. Your earnings that you get inside the Roth IRA are tax free only if you’ve had a Roth IRA in existence for 5 years. Christine: Okay so starting it now gets that clock running. Natalie: Right and you may be convinced you never want to convert to a Roth IRA but maybe you know 10 years from now you might change your mind and if you open a Roth IRA today you’ve already passed the 5 year clock for your future conversion you might do. Christine: Okay. Natalie: And the second reason to do it today is I suspect there might be a year end rush this year on Roth conversions as you pointed out the ceiling has been lifted this year so why isn’t everybody rushing to do this and its hard to decide people are uncertain but one thing will make a Roth IRA conversion profitable is if your tax rate goes up in the future. Christine: Right. Natalie: Tax rates are scheduled to go up in the future and starting next year when the so called bush tax cuts expire and if Congress does nothing they will go up. I have a feeling that if Congress does nothing along about thanksgiving people are going to start focusing on this and saying my tax rate really is going to go up. Christine: Can I do. Natalie: Right. Christine: Right. Natalie: And there may be a rush for the exits at that point well there’s two steps to doing a Roth conversion. You open the Roth IRA and then you transfer money into it from your other traditional plan. If you’ve already done step one open the account then if you get that year end urge to do more you made it easier for yourself all you have to do is just transfer some more money into it. Christine: Okay so getting started now is a key tip any other things to do right now or things to think about in terms of whether this is an appropriate move for you? Natalie: Whether it’s an appropriate move for somebody? Well the numbers guys tell me there are 4 factors if you can guarantee these 4 factors will exist then its going to be to you to be a moneymaker for you. Christine: Okay. Natalie: Your tax rate is going up in the future. You can leave that money in for a long time. Either during your retirement years or over beneficiaries life expectancy. Christine: How long is long. I know that it really depends but. The longer the better but I mean if you know you have to take it out next year its worth doing so but 5, 10, 20, 30 years then we’re done. I got to be able to pay the tax on the conversion using outside of the planned dollars. Natalie: Not the IRA assets themselves. Christine: Right, right. Natalie: And the fourth is that the investments go up which nobody can guarantee so. Christine: So let’s talk about some of the key traps that you want to think about if you are considering your conversion so obviously pulling the money out to pay the taxes is a bad idea? Natalie: Yeah. When you fill out your form to do a conversion there’s a little box you have to check to say I don’t want income taxes withheld. Big trap if you don’t check that box you’re going to find some of the money went to the IRS, you’ve got to name a beneficiary for that Roth IRA you create. Even if you’re sure you’re going to undo the conversion next year you could die in the meantime you need to have a beneficiary on that account. And the worst time for Roth IRA would be to commit a prohibited transaction with your with your Roth IRA that would be like buying or selling assets to your Roth IRA, renting an apartment to your kid or something in your IRA own investment because that disqualifies the Roth IRA and makes all the distributions taxable to the extent you will see your contribution. It’s like the death penalty plus being condemned to hell forever. Christine: Okay bad. Natalie: Very bad. Christine: So Natalie I know there had been a lot of talk that there would be the stampede to convert. It doesn’t seem at lease anecdotally at least that there has been but it sounds like you think that interest will pick up as there becomes concern about some of these bush tax provisions. Natalie: Absolutely. Christine: Right. Natalie: Now maybe Congress will erase those tax increases so tax rates aren’t going to go up and everybody can coast along another year. Christine: Right. Natalie: But if these tax rates are really going to happen and it looks that way at the end of the year there’s going to be interest in this but maybe the best thing about this year’s opportunity is that’s it’s going to force all of us to talk with financial advisers and really plot out what our income needs are going to be what are tax rates are going to be, what our investment return is likely to be even if you end up not doing a conversion its good that we’re being compelled to have those conversations. Christine: Well Natalie great insights as always thanks for summing it up for us and we appreciate you being here. Natalie: You’re welcome Christine. Christine: Thanks for watching I’m Christine Benz.
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