If you’re thinking about starting or adding to an Individual Retirement Account this tax season, here’s another reason to consider it: By moving now you can take greater advantage of a special tax-saving rule that will apply in 2010.
That rule will encourage people to shift money from traditional IRAs into Roth IRAs. Currently, many investors can’t open Roths because their income is too high. Others have stakes in traditional IRAs but prefer the tax edge on Roths.
The new rule aims to encourage conversions as a way to raise cash for the government, since conversions trigger taxes. Otherwise, Uncle Sam must wait for investors to cash out of their IRAs in retirement before collecting anything.
To encourage conversions, “Congress came up with an incentive carrot to dangle in front of (investors),” said Stanley Reynolds of American Financial Associates in Phoenix.
But first, some background.
With traditional IRAs, eligible participants can deduct their investments, but they face income taxes later when withdrawing money. With Roths, investors don’t get a deduction but do benefit from tax-free withdrawals. Such withdrawals would become especially valuable if tax rates rise.
As it stands now, many investors can’t transfer or convert traditional IRAs into a Roth, either because their income is too high (the limit is $100,000 for singles and married couples) or because they don’t want to pay taxes prematurely.
That’s where the incentives come in. Starting in 2010, anyone will be able to convert, regardless of income. Also, for conversions done in 2010 only, investors will be able to spread the resulting tax liability over two years, paying half in 2011 and half in 2012.
“The 2012 tax-return payment will not be due until April 15, 2013,” said Reynolds. “So a conversion on Jan. 2, 2010, does not have to be fully paid for nearly two and a half years.”
The conversion argument is compelling if you think tax rates are headed upward as the nation grapples with ballooning entitlement programs and a massive federal debt. Today’s ordinary-income rates are among the lowest in decades.
If you can’t qualify for a Roth, Reynolds suggests putting cash into traditional IRAs, of either the deductible or nondeductible variety, with an eye on converting them later.
Speaking of tax savings, municipal bonds are looking more enticing.
Amid the recent flight to quality, many investors have piled into Treasury bonds while neglecting other fixed-income investments. In particular, tax-free muni bonds seem to offer solid bargains, said Stephen Barnes of Barnes Investment Advisory in Phoenix.
Since munis pay tax-free interest, they normally yield a bit less than Treasuries, to which they’re compared. But with Treasury prices up and munis down, that link is out of whack.
“Normal spreads for muni-bond yields are something like 85 percent of Treasuries,” said Barnes. “Today, muni bonds are trading at yields of about 115 percent of Treasuries.”
For example, top-rated munis maturing in 10 years recently yielded more than 4 percent, compared with 3.5 percent for 10-year Treasuries.
Munis can be bought as individual bonds or within mutual funds or other diversified, professionally managed portfolios.
To paraphrase Yogi Berra, the tax-rebate program won’t be over until it’s over. New wrinkles and questions about the plan just keep popping up.
For example, the Internal Revenue Service recently clarified that combat pay can be used to qualify for rebates.
Combat pay normally isn’t taxable, so many military personnel don’t file a tax return. But they should file this year to receive a rebate, says the IRS. Military personnel thus join some retirees, disabled people and others in qualifying for the rebates despite having little or no taxable income.
Because of confusion over rebates, the IRS is trying different ways to get the word out.
That includes a series of short videos on YouTube. Two key messages: You need to file a tax return to get a rebate, and you should beware scams linked to the rebate program.
