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Investing Tip of the Month
by Christine Benz, Director of Personal Finance at Morninstar
You may have seen several mentions of the so-called backdoor IRA during the past year and a half. Despite its illicit-sounding name, this maneuver is perfectly legal, and it can help you diversify your retirement portfolio’s tax treatment.
However, if you have other IRA assets that haven’t been taxed yet, you need to think twice before engineering a backdoor Roth. If you don’t, your new Roth IRA could cost you a lot more in taxes than you had planned.
Before getting into how a backdoor Roth can be costly from a tax standpoint, let’s first discuss how this move, when properly executed, works and how it can be beneficial for savers in certain instances.
First, it’s worth noting that a backdoor Roth is only appropriate for those who earn too much to contribute to a Roth the conventional way: For 2010, the maximum adjusted gross income cutoff for married couples filing jointly is $177,000 and the income limit caps out at $120,000 for single filers. If your household’s income is below those thresholds, you can get into a Roth through the front door.
But assuming that your income is higher than that, you can take advantage of the fact that beginning in 2010, there are no longer any income limits on who can convert a traditional IRA to a Roth. Don’t ask me why Congress has left open this gaping loophole, because it doesn’t lead directly to new tax revenue, but for now it provides a way for higher-end investors to get new assets into a Roth.
Say, for example, a 55-year-old with an adjusted gross income of $185,000 and no other traditional IRA assets puts $6,000 into a traditional nondeductible IRA. (The “nondeductible” piece means that his contribution consists of money that has already been taxed; he can’t deduct his contribution on his tax return because he earns too much.) He could then immediately convert that IRA to a Roth, thereby ensuring tax-free withdrawals on that money in retirement.
Normally, the big hitch with an IRA conversion is that converters owe taxes on the part of their IRAs that haven’t been taxed yet, such as any deductible contributions or investment earnings, including money rolled over from a traditional 401(k). But assuming the backdoor converter doesn’t see the value of his IRA shoot up between the time he opens his account and the time he converts, his tax bill on the conversion would be minimal or even zero. That’s because he already paid taxes on his contribution, and he’ll have limited to no investment gains on which he’ll owe taxes at that point. In addition to avoiding taxes on the conversion, he’ll also have gotten some of his retirement assets into the tax-free withdrawal column, which is beneficial for people like him who have, up until now, earned too much to contribute to a Roth IRA.
The Maneuver Gone Awry
Remember, however, that the above example hinged on the fact that the backdoor IRA converter had no other traditional IRA assets. Let’s take a look at another example–one with other IRA assets in the mix–to illustrate how setting up a backdoor IRA can spell extra taxes.
Let’s assume a 32-year-old woman who earns $200,000 a year and has $20,000 in traditional IRA assets puts $5,000 into a traditional nondeductible IRA, seeking to take advantage of the backdoor conversion option. At first blush, it seems like this converter shouldn’t owe any taxes, either. Her contribution to the new IRA, as in the previous example, was already taxed, and if she makes the conversion right away, before her investment goes up in value, she wouldn’t owe any taxes on investment gains, either.
But here’s where the tax pain comes in. Her other traditional IRA assets consist entirely of money that she had rolled over from an old 401(k) plan, meaning that money has never been taxed. (With traditional 401(k)s, you’re not taxed upon your initial contribution and you’re not taxed on your investment gains until you begin taking money out.)
Because of those other IRA assets, the tax she’ll owe upon conversion will depend on percentage of taxable versus tax-free assets in all of her IRA accounts, not just the one she just opened.
In her case, $20,000 of her IRA assets haven’t yet been taxed and her new nondeductible IRA contribution of $5,000 already has. That means that 80%, or $4,000, of her recent $5,000 contribution would be taxable upon conversion; only $1,000 (the other 20%) would not be.
All of this means that if you have other traditional IRA assets, or SEP and SIMPLE IRAs, you’ll need to proceed carefully before opening up a traditional nondeductible IRA with an eye toward immediately converting to a Roth. This maneuver can work beautifully for those with no other IRA assets, but it can be a tax headache with those who do. Check with a tax advisor before proceeding. You may also be able to conduct a series of partial conversions over time, thereby limiting the tax hit in any one year.
It’s also worth noting that you have an escape hatch if you would like to do a backdoor IRA but have other IRA assets that you’ve rolled over from a previous employer’s 401(k). Assuming your new employer also has a 401(k) plan that allows you to do so, you could roll the IRA assets into that plan, thereby reducing or eliminating the taxes owed upon conversion of a new backdoor Roth. Of course, the merits of this strategy will depend entirely on the quality and fees associated with the new plan.
A version of this article appeared on Morningstar.com on Jan. 3, 2011.
Investing Tip of the Month
By Christine Benz, director of personal finance
Morningstar is available online 24/7 from the Library.
For the past few years, my main tax advice during the fourth quarter has been pretty straightforward: Sell your losers and move on.
That’s because after the 2008-early 2009 bear market, most investors’ portfolios were replete with holdings whose prices were lower than what they had paid for them. By selling those losers out of their taxable portfolios, investors could realize tax losses that they could then use to offset capital gains and, if they had none of those, ordinary income. Doing so is one of a handful of ways to find a silver lining in a tough market environment.
But as we wind down 2010, the calculus for the tax-conscious is far from clear-cut. For one thing, both stocks and bonds have enjoyed robust gains during the past year, improving the odds that you’ll be holding securities at a gain, not a loss. In addition, tax laws are set to change in a big way in 2011, and these changes have significant implications for investors. Although it’s never a good idea to let tax considerations trump investment considerations–and Congress may still take action to alter the tax changes that are set to go into effect next year–it’s still worth bearing taxes in mind if adjusting your portfolio is on your fourth-quarter to-do list.
So what’s on tap, with regard to taxes, for 2011? For starters, the current 15% capital gains tax rate will jump to 20%. And things are poised to get even uglier for dividend taxation. Most investors currently enjoy a very low 15% tax rate on dividends, and those in the lowest tax brackets currently pay no dividend taxes at all. But unless Congress takes action, investors will owe ordinary income taxes on their dividends beginning in 2011. In essence, dividend income will be treated exactly as bond income currently is from a tax standpoint. There’s widespread speculation that Congress will cap the dividend tax rate at 20% before the onerous new rate goes into effect–thereby once again putting dividends on an equal footing with capital gains from a tax standpoint–but that’s not a done deal.
Additionally, income tax rates are also set to head up next year for higher earners. Those who are currently paying taxes at a rate of 33% will owe ordinary income taxes at a 36% rate, while those in the 35% tax bracket will owe taxes at a 39.6% rate come next year.
If those changes do go into effect, investors might question what kinds of strategies will make the most sense. Consider the following, while bearing in mind that a lot can change between now and year-end.
Strategy 1: Take a Close Look at Big Winners
Tax-loss selling has been a no-brainer for investors’ taxable accounts for the past few years. But this year, another strategy makes even more sense: selling securities that have gone up a lot since you bought them, particularly if you were considering lightening up on them anyway. Say, for example, you put $10,000 into an emerging-markets fund in 2003, and your position is now worth about $38,000. If you rebalanced back to your original position size in 2010 (that is, you sold $28,000 worth of your holdings), you’d owe taxes of about $4,200. But if you waited until next year, your tax hit would jump to $5,600.
Of course, taxes aren’t the only factor to consider in a decision like this. You’ll also want to consider the holding’s individual investment merits, its role in your portfolio’s asset allocation, as well as the potential (however slender) that capital gains taxes won’t in fact revert to 20% next year before pulling the trigger on a winning holding. But if you conduct a portfolio review and determine that some rebalancing is in order, better to sell now than wait until next year.
Strategy 2: Rethink Your Tax-Loss Strategy
While you’re evaluating your cost basis in various securities in your taxable portfolio, bear in mind that tax losses may be more valuable to you in the years ahead, under a higher-tax regime, than they are right now. Of course, if you’re realizing a lot of capital gains this year or triggering a large income-tax bill via an IRA conversion or some other activity, it’s probably worth scrounging up any offsetting losses you can find–regardless of tax rates. It’s also worth bearing in mind that your tax position in a holding is fluid–what’s a loss today may not be tomorrow if the security appreciates. So if you have a losing position you’d like to unload no matter what, you’re probably better off getting rid of it sooner rather than later, even if that loss may carry a greater tax advantage next year.
Strategy 3: Pay Conversion Taxes Now Rather Than Later
For those who are concerned about higher taxes–not just next year but in the many years ahead–converting a traditional IRA to a Roth IRA looks like one of the biggest layups out there. You’ll owe taxes on the taxable portion of your balance when you convert, but you won’t owe any taxes when you withdraw the money. Moreover, in 2010 the tax code eliminates the income limits for higher-income investors to convert in 2010, and it further sweetens the pot for all investors by allowing them to defer taxes due on 2010 conversions into 2011 and 2012.
Converting can make a lot of sense, but conduct a thorough analysis before taking advantage of the government’s offer to push your conversion-related tax burden into 2011 and 2012–especially if you’re a higher-income earner who will be in a higher tax bracket in those years. A tax advisor can help you weigh whether taking advantage of today’s lower tax rates helps offset the opportunity cost of forking over a large sum of money this year (thereby forgoing any gains you’d earn if you hung onto that money and paid the taxes in 2011 and 2012).
Strategy 4: Start Rethinking Asset Location
As I noted above, the taxation of dividends at ordinary-income tax rates beginning in 2011 is far from a done deal. And until there’s more clarity, I’d advise not making radical changes to the dividend component of your portfolio based on prospective tax changes alone. But if you’ve held dividend-paying stocks and funds in your taxable account because of favorable tax treatment, it’s not too soon to think about the implications a dividend-tax increase would have for your asset location–what types of assets you hold in which accounts. Prior to the dividend tax cut in 2003, the classic strategy was to hold non-dividend-paying equities and municipal bonds in taxable accounts while reserving dividend payers and taxable bonds for tax-sheltered accounts. Under a higher dividend-tax regime, that framework would make sense again.
Strategy 5: Revisit Municipal Bonds
Last but not least, impending changes in income-tax rates should prompt higher-income earners to revisit whether municipals aren’t a better deal than taxable bonds. The 36% marginal income tax rate will kick in for single folks with income between $192,000 and $375,700; married couples filing jointly with incomes between $232,950 and $375,700 will also be taxed at that rate, according to the Tax Policy Center. Meanwhile, the 39.6% rate will apply to individuals and couples with incomes of more than $375,700. Municipal bonds were probably a good bet for those individuals and couples even before the tax hike, but they’ll be an even surer thing under a higher-tax regime. And while I generally prefer national muni funds versus ones that stick with a single state because of the former’s diversification benefits, the fact that tax rates in many states are apt to creep up may mean that single-state munis’ tax ben efits outweigh the forgone diversification benefit.
A version of this article appeared on Morningstar.com on Oct. 11, 2010.
The Bush tax cuts are set to expire by law on December 31, 2010. Recently, the Republicans and some moderate Democrats have campaigned to restore the Bush Tax Cuts, especially for the top 2% of taxpayers because they claim that this would help create jobs, or at least prevent more jobs from being eliminated. Most Democrats believe that tax cuts for the rich should be eliminated, but the tax cuts for middle- and lower-income earners and small business should be maintained.
The Democrats argue that because most poor and middle-income families consume their entire income, higher tax rates for those families would indeed deprive the economy of much-needed short-run stimulus. But extending the Bush tax cuts for the wealthiest families would have significantly less impact as a stimulus because these families typically consume much less than their income. Eliminating tax cuts for those who have incomes above the $250,000 threshold would increase federal revenue, help reduce the deficit, and little impact on their quality of life.
Also, the additional revenue from those who benefited the most from a decade of reduced taxes can be used to bolster spending and investment in a host of ways that would be useful even apart from the stimulus effects. Because state and local government budgets are in shambles, hundreds of teachers, police officers, and firefighters are being laid off every week. Federal grants could keep them on the job.
States around the country have also been allowing thousands of miles of asphalt roads to deteriorate back to gravel, even as skilled workers and heavy equipment stand idly by. The eventual bill for repaving those roads will add much more to deficits than if we had maintained them properly in the first place.
Students need to be able to understand the conditions and reasoning that lead to the Bush Tax Cuts and whether or not they were effective in creating a robust and expanding economy. Assign students to write a report of at least 150 words that cites at least three sources and addresses the following examples of essential questions for critical thinking (you may add or substitute others):
- What were the “Bush Tax Cuts” and what were they designed to accomplish?
- What other tax strategies were proposed at that time as an alternative?
- What problems did President Bush have in passing the tax cuts?
- Do you think that they worked in creating more prosperity for the average citizen—why or why not?
- Would extending the Bush Tax Cuts help create jobs and lower the deficit—why or why not?
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Type “Bush Tax Cuts” in the Search box
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