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IRA
Wall Street Has One Answer to Wealth Creation; Another is Tax Reduction
By Wayne Michael Lottinville, CFA
Chief Investment Officer, Cascadia Investment Consultants
There are more ways to generate wealth than relying
on what Wall Street has to offer. One of the better
alternatives, in fact, is to invest in reducing your
taxes. You may have made $1 million in the market
last year, but if your marginal tax rate is 35%, in an
extreme case you could possibly be left with just
$650,000. Even onerous investment commissions
and fees can be significantly less than the bite of the
tax assessor.
How, then, to reduce this bite? Here’s a medicine
that could be hard to swallow, but that could
improve your future financial health and wealth.
Convert to a Roth IRA
Conversions to a Roth IRA are taxed today. But
wait, weren’t we going to reduce taxes? The beauty
of the Roth IRA is that while you pay taxes on your
conversion today, you can later make qualified
withdrawals completely tax-free. Furthermore, now
may be the best time to convert your non-Roth
IRAs (such as a traditional IRA, SEP, or SIMPLE).
Yes, income taxes today are painful, but the fact is
that they are lower now than at any time in recent
history. With the federal deficit ballooning, trade
imbalances threatening, and Baby Boomers soon
making claims on Social Security benefits, many
analysts predict that tax increases are now much
more likely than additional tax decreases - regardless
of which party wins the White House.
If this is true, then it may make a lot of sense to
convert your non-Roth IRAs into Roth IRAs today
and—however painful—pay today’s lower taxes.
Think of it as a long-term investment where you pay
taxes today for a return of no taxes in the future.
Consult with your tax and financial advisors to
determine if conversion makes sense for you and if
you qualify. Here are a few questions to consider.
How long will it be before you withdraw the
converted assets? The longer the better so that your
converted assets will have a good change to grow.
Ten years or more offers the greatest potential
benefit.
Will your tax rate in retirement be the same as it is
now or higher? If so, conversion makes a lot more
sense. Again, many economists predict that tax rates
must increase to pay our country’s increasing debts.
Will conversion put you in a higher tax bracket in
the year of conversion? If so, you may be able to
avoid the increased marginal tax rate by doing a
partial conversion this year and the remainder next
year or later.
The Most Difficult Requirement
Will you be able to pay the additional taxes out of
your taxable assets? This will be difficult for those
already stretched thin, but you do not want to use
converted IRA assets to pay the taxes due on the
converted amounts. In addition, conversion could
trigger estimated quarterly taxes. Ouch!
Will rates of return on converted assets be high
enough to compensate for the immediate tax
liability? With a well-diversified portfolio and
sensible asset allocation, you are likely to achieve a
return in the next 10 to 20 years that more than
compensates for the immediate tax liability. In fact,
this is one of the better reasons for converting now.
Lastly, do you expect that your beneficiaries will
inherit the converted assets? Regarding taxes, a Roth
IRA may be easier on your heirs than a non-Roth
IRA.
This is just a starting point. Check out Vanguard for
a fairly simple preliminary calculator where you can
get an idea of whether it makes sense for you to
convert to a Roth IRA. Perhaps the easiest way to
get there is go to Vanguard.com, then search for the
phrase "should I convert." Again, if you decide that
you might want to convert to a Roth IRA, check it
out first with your tax and financial advisors.
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