Avoid the Tax Trap of 401Ks & Other Qualified Plans: Part I the Roth Conversion

So you're getting near retirement or perhaps already there and now realize that you can't touch the money from your 401k, IRA or other qualified plan without paying taxes on dollar ONE!  Yes, you dutifully funded this most of your working life and got to defer the taxes. Good for you?!  You see you not only deferred the tax but the tax calculation so now you pay tax on ALL the money you put in, ALL the money your employer put in AND ALL the gains made on the account.  So there's only one other pressing question to answer, "Do you think taxes are going up or down in the future?"

We'll we know that for many taxes will be going up in 2011. Although it may not feel like it, we've enjoyed some fairly low taxes over the last few years; in fact the lowest in our history. Did you know that, since the inception of income taxes, the average rate has been 65%. THAT'S THE AVERAGE! Here are 3 things we know:

* that the feds need money to cover their "drunken sailor" spending (no offense to drunken sailors)* because of this fact, taxes will be going up (starting next year) Unless of course they "sober up" & extend Bushes tax cuts. Groucho Marx said it fairly succinctly, "Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies."* the income tax went to 65% during the Great Depression and we're in similar conditions.* (BONUS) it's reasonable to assume our taxes are going up a lot more than we realize; directly & indirectly. Or as Groucho said, "Are you going to believe them or your own eyes?"

So given the current state of affairs, what can you do? Here are two options: Convert to a Roth IRA or strategically roll out this taxable environment into a deferred product where you control when you pull money out and pay tax and then only pay tax on gains. First the Roth.

Here are the benefits of a Roth Conversion:

* Pay the tax now while it's still relatively low. (Since tax has never been paid on this money, you have to pay the tax on dollar one of whatever amount you want to convert.)* But, If done this year (2010), you have three (3) years to pay the tax; no tax this year, 50% in 2011, 50% due by April 15, 2013.* Once converted it grows TAX FREE...* Take it out as retirement income TAX FREE...* And goes to your heirs TAX FREE... (seeing a pattern here?)* No RMD's (Required Minimum Distributions) Unlike IRA's you also avoid having to take the money out at age 70 1/2.

Here's the downside: YOU HAVE TO PAY THE TAX! But you can control this by the amount you decided to convert (you don't have to convert it all) and you have virtually 3 years to pay it so you can stretch it out. It's best to have other non-qualified savings to pay the tax. (non-qualified funds are things like CD's, Brokerage accounts, Mutual Funds that are not IRA's, 401k's, 403b's etc.) Here are the reasons to use non-qualified funds to pay the tax:

* If you pay the tax out of the qualified plan you'll drastically reduce your after tax retirement savings.* By Paying the tax out of NON-qualified funds you're paying it with money that will be taxed anyway. Remember that the gains from CD's, Brokerage accounts, Mutual funds etc are taxed each year whether you use the money or roll it back into the account. This reduces your overall rate of return. By using it to pay the tax, you keep the largest amount in a TAX FREE account that will enjoy triple compounding; make interest on the money, interest on the interest and interest on the money you would have sent away as a tax (opportunity cost).

So you may still be wondering if a Roth Conversion is right for you. Here some considerations that will help you decide:

* If you have to pay the tax out of your qualified savings and you are going to NEED THIS MONEY TO LIVE ON, then it may not be a good idea to convert.* If you don't need this money and it's all going to the heirs then it may be a goo idea.* If you're younger, under age 65, a conversion might work if you have time to grow back the amount you have pay in tax.

To view my complete seminar presentation on Roth conversions, just click on the link in the upper right hand corner of this page on the Roth Coversion button.

I'll cover another option to strategically role out of your qualified tax trap in my next post.

Safe savingsRoger