On this Election Day, I'm going to make a bold, political prediction: Twenty years from now, federal income taxes are going to be higher than they are today.
It doesn't matter which party controls Congress or the White House in 2028. The pressure from budget deficits and retired baby boomers collecting Social Security and utilizing Medicare will be so great in the years ahead, it's quite likely taxes on ordinary income and capital gains will rise from current levels.
That's why you might want to consider converting your traditional IRA or former employer's retirement savings plan to a Roth IRA in 2008. This is one way to come out a winner from the recent stock market dive -- by paying lower taxes now rather than at higher rates later.
A 40 percent drop in the value of your retirement portfolio this year means you could save 40 percent on the cost of converting to a Roth IRA. That long-term savings, coupled with the prospect for higher taxes in the future, could more than make up for this year's short-term market losses.
First, let's take a look at the basics of retirement-plan taxation.
With most retirement savings plans, participants pay no income tax on their contribution amounts, saving them money on the front end. As long as the money remains in the retirement plan, investment earnings and growth are sheltered from taxation.
Then when the money is withdrawn in retirement, account owners pay what's due to Uncle Sam in the form of ordinary income tax. The plans that fall into this category include traditional IRAs, 401(k) and 403(b) accounts and other workplace retirement savings accounts.
With a Roth IRA -- or the newer Roth 401(k) -- the tax benefits are arranged in the opposite order. There are no tax savings on the front end for contributions made; however, when retirement rolls around, no income taxes are due on amounts withdrawn from Roth accounts, assuming all requirements are met. As with other types of plans, earnings in a Roth account are sheltered from taxation.
Now, imagine you are retired 20 years from now. How much further will your nest egg go if no taxes are owed? Quite a bit, particularly if, as I expect, income tax rates are higher than they are now.
Another Roth advantage is that there is no requirement for mandatory distributions after reaching age 70 ½ as there is with traditional IRAs and other retirement plans.
You can reap the advantages of a Roth IRA by setting up one through a mutual fund family or other investment firm and contributing on an annual basis, provided you meet the income requirements.
But you can also reap the advantages by converting what is now a traditional IRA or other retirement savings plan into a Roth.
The big downside of a conversion is that you pay taxes on whatever amount you convert in any given year. For instance, imagine you had a $10,000 traditional IRA at the start of this year and converted it to a Roth IRA at that time. When you file your 2008 tax return next spring, you would owe income taxes on that $10,000 conversion amount. For someone in the 15 percent tax bracket, the federal income tax on the conversion amount would be $1,500 -- a major hurdle for many middle income taxpayers.
But if you waited and the same IRA account stood at $6,000 after a 40 percent fall, the taxes on the lower Roth conversion amount would be $900 for someone in the 15 percent bracket. If you're in an even higher tax bracket, the savings are even greater.