Dave Carpenter, AP Personal Finance Writer
CHICAGO (AP) — Why pay taxes before you absolutely have to? Because you may pay significantly more if you wait.
The prospect of higher tax rates is prompting a new wave of interest in Roth IRA conversions by people who want to lock in current rates or take advantage of a significant one-time tax advantage that expires at year's end.
Financial services firms including Bank of America Merrill Lynch and Principal Financial Group, as well as financial planners, report an uptick of conversions and queries in recent weeks. After Election Day, Congress will resume the debate over possibly increasing federal taxes.
Roth Individual Retirement Accounts are widely touted as paying off for just about everyone in retirement. Converting a traditional IRA to a Roth enables you to benefit from tax-free growth in the account and you won't pay taxes on withdrawals in retirement.
The tax-free growth can be indefinite because you'll avoid the requirement of traditional IRAs and 401(k)s that owners take withdrawals from their accounts every year after age 70½, resulting in taxable income. And if you end up not dipping into it at all, it will be a tax-free inheritance for your heirs.
But what if you're nearing retirement and unsure whether the possibility of a slightly higher tax rate after your working years makes it worth taking the tax hit now? That can be a tougher call, perhaps worth consulting a financial adviser about.
"Anyone with a significant balance in an IRA should at least evaluate a Roth conversion before the year ends," says Ed Slott, a Rockville Centre, N.Y., accountant and publisher of the IRA Advisor Newsletter.
A surge of Roth conversions took place earlier this year, because households with more than $100,000 income were newly eligible. Here are reasons why it's important to take one more look at the Roth-or-no-Roth decision soon, and points to consider when you do.
PAY TAXES AT CURRENT RATES.
Converting no later than Dec. 31 will enable you to lock in today's tax rates, which could be rising as soon as 2011 as both federal and state governments seek to address huge deficits. After a lull since tax season, there's been an increase in Roth calls and queries to financial firms. Merrill Lynch says it did as many conversions in August as in all of 2009.
The tax advantage of converting now doesn't mean everyone should do it. It probably doesn't make sense if you are a retiree drawing on an IRA to meet living needs, or if you think you will be tapping it in the next five years or so. It also may not be advisable if it pushes you into a higher tax bracket. This may happen because any portion of your traditional IRA that hasn't already been taxed will become taxable income from the conversion.
If you are confident you will be in a lower tax bracket at retirement, there's also no rush to convert. But don't take that for granted. Not only are rates likely to rise, but you could have substantial taxable income from Social Security, pension and investments.