Benjamin Franklin is credited with saying, “In this world nothing is certain but death and taxes.” I’m certainly no Ben Franklin, but I’d like to be credited with saying there is nothing certain but confusing federal tax law changes. Franklin was talking about taxes on tea and stamps. I’m talking about the 2005 Tax Increase Prevention and Reconciliation Act and, specifically, the rules governing the conversion of traditional IRAs to Roth IRAs.
An individual retirement account (IRA) is an account that allows earnings to compound over time on either a federally tax-free or tax-deferred basis.
Traditional IRAs offer tax-deferred growth of either pretax or post-tax contributions or balances rolled over from employer-sponsored retirement plans like the Thrift Savings Plan.
Roth IRAs offer tax-free growth on post-tax contributions.
Currently, if you are 49 years old or younger, you can contribute up to $4,000 per year to an IRA. The amount increases to $5,000 for people age 50 and older.
Current law also restricts taxpayers who the government deems to make too much money from converting their traditional IRAs to Roth IRAs. Only taxpayers with an with adjusted gross income of not more than $100,000 during a given year are allowed to convert a traditional IRA to a Roth IRA in exchange for paying any taxes due on the converted amount.
This income limitation has prevented many traditional IRA owners from converting their accounts to Roth IRAs.
One of the provisions of the 2005 act repeals this income limit beginning in 2009.
This new law effectively removes the effects of the annual contribution limits to Roth IRAs for those who have substantial traditional IRA balances that they want to convert to Roth.
Under the new law, separating feds will have the option of rolling their TSP balance into a traditional IRA and then converting this account to a Roth IRA, regardless of their income.
A potential advantage of making a conversion is an increase in the after-tax balance produced in the account over time.
A disadvantage is that taxes must be paid at the time of conversion. The additional taxable income produced by the conversion may mean paying taxes at higher marginal rates than those that would apply if the taxes were deferred until later.
The new tax law does provide a slight break to the taxpayer. Taxable income reported from conversions made in 2009 may be spread over two years — 2010 and 2011 — to ease the burden, and to potentially reduce the total tax liability produced by the conversion.
While it is tempting to assume there are large advantages to converting to a Roth IRA, any actual advantage will depend on your financial circumstances and the future course of events — a course that may be difficult or impossible to predict.
Generally, the advantage of a Roth IRA over a traditional IRA depends on either decreasing future tax rates or paying taxes due on converted amounts with funds from outside the converted IRA — effectively increasing your Roth IRA contribution.
For example, assuming a constant 25 percent tax rate is applied to all taxable income, contributing $1,000 pretax to a traditional IRA and contributing $750 post-tax to a Roth IRA will produce the same after-tax retirement income stream. By paying the $250 tax due on the conversion using taxable savings and increasing the Roth IRA contribution to $1,000 you can effectively convert an additional $250 from taxable to tax-free savings and create an advantage for the Roth IRA over the traditional IRA — the value of the future taxes saved on the $250 investment.
If tax rates rise, the Roth IRA will produce greater returns than the traditional IRA, all other things being equal.If tax rates fall over time, a traditional IRA will perform better.
Financial service providers are already preparing their strategies to convince investors to begin preparing to take advantage of the new law. If history is any guide, many of these strategies will rely on biased information and arguments designed more to generate commissions than to further your interests. So use caution in making decisions about converting your accounts and make certain to objectively consider all of the risks and options.
In particular, avoid the temptation to move your assets from the TSP — arguably the best retirement savings vehicle available anywhere — to a higher cost, higher risk and probably less productive IRA in order to pursue an uncertain and possibly irrelevant tax advantage. As you analyze your own financial circumstances, it may be easiest to remember that a TSP saved is a retirement earned. I think Benjamin Franklin could agree with that.
Written by Mike Miles
For the Federal Times
Publication June 12, 2006