By Jim Brogan
So much of the public debate right now is centered around health care that the national debt issue has essentially been pushed to the background. But the reality is that the government is creating larger and larger deficits.
As of mid-October, our federal debt is up to $11.9 trillion. But this really only is the tip of the iceberg in terms of our future liabilities. According to the 2009 Social Security and Medicare Trustee’s Report, the unfunded liabilities of Medicare and Social Security is $107 trillion in today’s dollars. That’s about seven times the size of the U.S. economy and almost 10 times the size of the outstanding national debt.
At some point we’re going to have health care reform in place. When that happens, I think it’s fairly certain that will usher in an era of higher income tax rates. Certainly income tax rates are going to go up for the highest taxpayers – no news there. But when you look at the math for how to pay for all this, it becomes apparent that higher taxes are on the way for most people who pay income tax.
Despite these tax concerns for the future, some tremendous opportunities exist because of some new laws that are scheduled to take effect in 2010. One thing we certainly have to be aware of is that the rules are changing on Roth IRA conversions.
As IRAs and retirement account balances continue to grow, they are great places to accumulate money because of the triple compound interest we receive. We get interest on our principal, we get interest on our interest and we get interest on our share that we owe to the government.
We’ve never paid income tax on most – if not all – of the money in our retirement accounts. So these accounts are ideal for accumulation, but it can become very problematic when we want to start taking money out. And it’s very important to realize when we look at our retirement account balances that we do not own all of that money. We have a partner and that partner is Uncle Sam.
When they retire, a lot of people look at their account balances and feel like they’ve crossed the goal line and locked up the game. But the reality is it is only halftime. We’ve all heard the expression, “It’s not how much we make, it’s how much we get to keep.” There is no area where that is more true than when it comes to distributing retirement accounts.
As we continue to grow those accounts in our working years, we are creating more and more of a tax problem for ourselves in retirement, because I think it is fairly certain that our tax rates are going to go up. If you are looking at retiring in the next 10 years, you’re probably going to be retiring in a much, much higher tax environment. We really don’t know what that account is truly going to be worth to us because we don’t know what tax rates are going to look like in the future – just that they’ll quite likely be higher.
Now for the good news. Starting in January of 2010, we can do Roth IRA conversions regardless of our income. This is new. In the past, in addition to not being able to add to a Roth based on income limitations, we could not even convert monies to a Roth based on income limitations.
No matter how much money you make in 2010 and beyond, you can utilize a Roth conversion – one of the most popular ways to convert money to being tax-free forever. If we can reposition money from always being taxed to being forever tax-free – particularly with where we’re headed economically – I think it is very wise to closely consider such an option.
If you were to convert, say, $50,000 into a Roth from a traditional IRA, you have to pay income tax immediately on the $50,000 at your current tax rate. If you do that in 2010, you can either report all $50,000 in 2010 or spread it with $25,000 into 2011 and $25,000 into 2012. If you choose to delay and split it, you would then pay income tax on each $25,000 at the 2011 rate and 2012 rate. This is a decision you wouldn’t actually have to make until April 2011, when you file your 2010 tax return.
Historically, we are in a very low tax environment (see chart). It has been that way since the late 1980s, but is compounded with huge government deficits and debt, and unfunded liabilities with Medicare and Social Security. When you put all of that together, I see a much, much higher tax environment on the horizon for the majority of taxpayers, but especially for top earners.
That being the case, I believe the best plan would be to go ahead and pay the income tax on the conversion now while income taxes are relatively low.
Once you have had the Roth account for five years, you can draw not only the principal tax-free, but the interest grows tax-free forever. It is important to note that during the five-year period, you can take your principal with no tax implication whatsoever; the five-year period applies to the interest only.
Of course, you do have to be at least 59½ or you would have a tax penalty on the interest in addition to the tax. But once you reach 59½ and have waited five years, not only is the principal tax-free, but the interest is tax-free.
If a Roth conversion is right for you, 2010 could start out as a happy new year indeed.
Jim Brogan is the president of Brogan Financial Inc., a local firm that specializes in comprehensive wealth and distribution planning. He is a member of the nation’s most exclusive group of financial advisors -- Ed Slott’s Elite IRA Advisor Group™. He can be reached at 865-862-6800.
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