If there is still one good tax-advantaged thing about living in Illinois its the tax code for seniors and retirees. With all the turmoil in Springfield over budgets, Illinois is still tax heaven for those on pensions.
If you have one or more, and have filed your taxes since you have received those hard earned dollars, you know what I mean. No state tax on retirement accounts, pensions, IRA’s, and annuities for now anyway, and I am not aware of anything in the present legislature that is destined to change it.
With all these opportunities in the prairie state to retire with a little extra saved from the state treasury, there is naturally deep interest in IRA’s.
There are two major types. The conventional, and original IRA known commonly and correctly, simply as the “Traditional IRA”, short for Traditional Individual Retirement Account, and the newer kid on the block, the “Roth”.
The basic difference between the two is when you pay the piper. With the Roth, you hand over the cash to the miller for the wheat when you buy the seed. With the traditional IRA, you get the seed free but, pay at the end, when the crop is harvested and hopefully worth a lot more than when you started planting.
What you really receive with the Roth IRA is something of an agreement with the government that says if you follow certain provisions, and comply with the restrictions, and are otherwise eligible, you will be allowed to invest so much money into an account that will not only grow tax free but, will be able to be removed at the end, without ever having to pay a penny to Uncle Sam.
The primary difference between the “Roth” and the “Traditional” IRA, is that the traditional gives you a tax break or deduction at the beginning, when you make the deposit. The Roth doesn’t.
However, down the road, at maturity, and certainly begining no later than age seventy and a half, you will pay taxes on the traditional IRA as the account comes to fruition.
By receiving a tax deduction at the start, the traditional IRA says you pay taxes at the finish line. With a Roth, no initial tax deduction, and no taxes paid at the end. Simple as that.
Otherwise, both IRA’s do basically the same thing, that is grow tax-deferred, or as in the case of the Roth, potentially, tax free.
The Roth IRA has been getting a lot of positive media attention lately. It’s the darling of the financial press and with some justification.
For one thing, 2010 is the year that the last of the restrictions have been lifted allowing those who made over $100,000.00, to convert their “traditional IRA’s” into Roth’s.
Why would one want to covert? Simple, it means with the money now in a Roth, you pay no federal income taxes at the end, when you start withdrawing from the portfolio. If you leave it in the traditional IRA account, you most certainly will, unless some less likely exceptions should occur.
Of course, there is a price to converting. There is a formula which shows how much Uncle Sam wants in tax dollars in order for you to switch from a traditional IRA to a Roth.
For example, lets assume a young age earner wants to drop their old-line traditional IRA for the newer Roth engine and has $50,000.00 they want to transfer over. Let’s also assume that they started out by putting in $10,000,00, which they got a tax deduction on, and the rest of the money was earnings.
Their bill from the federal treasury would be about $12,00.00 which means the day after their transfer was official, their account would now be worth $38,000.00. That is of course, assuming they didn’t pay the $12,000.00 out of other funds and left their IRA intact.
That’s the price our young person paid for altering their investment from traditional to Roth. Of course, now they get a tax free ride all the rest of the way, including and especially at withdrawal.
Let’s now assume our same young person has a good job with a very moderate income but, with the potential for constant but gradual increases over the next thirty five years, and little need for tax deductions. He would almost certainly fare better in a Roth, including with the above conversion.
The tax deductions he received on April 15th each year, very likely wouldn’t make up for the taxes he would pay when he withdrew his traditional IRA funds at retirement, versus the Roth where he would pay none at the end.
Although this might be more likely than not, this is not necessarily a given. The young person’s investments could change, he could lose money. He could suddenly get a new job with much higher income and the need for another good tax deduction, which could all spell advantages for the traditional IRA.
With many seniors and others approaching retirement the question of whether or not it is advantageous to convert, can be even more complicated.
How much are, and how will you pay the taxes due upon conversion? If you have a large sum in your retirement account, the conversion amount due, could be substantial. If you have to pay it out of the IRA, converting might not be fesible.
There are free conversion charts available online and through banks and brokerage communities.
But, this is only part of the equation. Will the impact of the conversion change your social security benefits? Are you planning charitable contributions? If so, it doesn’t make much sense to be paying taxes on funds you are going to be giving to the local church group.
Also, consideration of future tax rates, as well as income changes of the IRA owner and beneficiary could all have a bearing on the advantages or lack of them, of converting to a Roth.
Of course, one clear advantage, no more need to calculate RMD, otherwise known as Required Minimum Distribution, which all owners over age seventy and a half have to calculate and withdraw from their traditional IRA accounts.
Therefore, transfering to a Roth isn’t a given. I have an investment client that has been with me for ten years and retired all that time. He has a tidy sum in a traditional IRA and works with one of the top tax preparing firms in the Midwest, his personal advisor is both a lawyer and CPA, and previous employee of the IRS. Although he is required to take a considerable amount of funds out annually to pay the taxes on his RMD, there has never been any discussion between us to convert him into a Roth.
If you are just starting on your career, you certainly want to look at the advantages of an IRA, especially a Roth. If you are further along, and have accumulated a fair amount of funds in your traditional IRA account, you need to do some serious deliberating to determine whether it would be tax-advantaged for you to convert all, or even some of your funds.
Accountants specializing in personal taxes, many banks, brokerage firms, and others, have the capability to help in making conversion decisions.
John Seyman can be contacted at 630-355-0387. Personal Asset Management, Seco and Associates Ltd. PO Box 112, Naperville, IL. 60566, email: JSeyman@aol.com
