As the U.S. population gets older, more people, particularly baby boomers, are confronting a dilemma. As parents age, their ability to manage their own finances may decline. That can make it more likely that they may neglect the life savings they’ve worked so hard to accumulate or make costly mistakes with them. Even worse, they’re more likely to fall victim to one of the fraudulent schemes that frequently target seniors. “Financial Fraud and Fraud Susceptibility in the United States,” a September 2013 report prepared for the FINRA Investor Education Foundation, found that seniors were 34% more likely to lose money to fraudsters than were those in their 40s.
And yet many seniors, especially those who have always been independent and/or money-savvy, may be reluctant to accept advice or help from their children, or even discuss living expenses, health care plans, investments, or general estate planning. Sadly, postponing that discussion can increase the difficulty of tackling whatever problems may eventually arise.
Conventional wisdom holds that if you convert a traditional IRA to a Roth IRA, you should never pay the conversion taxes from IRA assets. The reason is that you’ll be depleting IRA assets that might otherwise be available to grow on a tax-deferred basis. The withdrawal from a traditional IRA to pay the conversion taxes is also a taxable distribution, generating an additional tax liability, requiring an additional withdrawal, and so on–plus you’ll generally pay a 10% penalty if you’re not yet 59½.
It’s also conventional wisdom that converting a traditional IRA to a Roth IRA is tax neutral so long as income tax rates remain the same at the time of conversion and after retirement.
Conventional wisdom isn’t always right
But there’s one scenario where conventional wisdom may not apply. This is best explained with an example.1 Let’s assume the following:
- You’ll be 59½ or older as of January 1, 2015, and you’ve had a Roth IRA for at least five years. So you’ll be eligible for tax-free and penalty-free qualified distributions from your Roth IRA in 2015.
- You’ve decided that it’s appropriate for you to have more retirement assets in a Roth IRA.
- You own a stock in your traditional IRA that you anticipate could be a candidate for higher-than-average gains. For example, let’s assume you own 10,000 shares of Acme Pharmaceuticals, a highly speculative biotech that has a drug pending before the FDA. The shares are currently trading at $10. After diligent research, you’ve determined that the Acme stock could climb to as much as $50 if the drug is approved by the FDA, but it is equally likely to drop to $1 if not approved. The FDA deadline for approval is October 1, 2015. (For simplicity, we’ll assume the Acme stock is the only asset in your traditional IRA and that you are converting the entire IRA.)
- You want to convert your traditional IRA to a Roth in 2015, before the potential appreciation in Acme stock, but you don’t have any cash available to pay the conversion tax, or you simply don’t want to pay the conversion tax from other (non-IRA) assets.
Now let’s further assume that Acme’s drug does receive FDA approval on October 1, 2015, and the stock does in fact jump from $10 to $50.
Result if you do not convert
If you did not convert your traditional IRA to a Roth IRA, your traditional IRA would now hold 10,000 shares of Acme stock worth $500,000. Again, for simplicity, let’s assume you sell the stock, your account now holds the $500,000 cash proceeds, and you make no further trades or contributions to the account. Assuming you earn 6% until your retirement in 10 years, your account would grow to approximately $895,000. Assuming a 28% federal income tax rate, the after-tax value of your account would be $644,705 at retirement.
Result if you do convert
Now let’s assume you did convert your traditional IRA to a Roth IRA before October 1, 2015. The stock was worth $100,000 at the time of conversion, and assuming a 28% tax rate, the federal income tax is $28,000, due when you file your 2015 tax return. On October 1, when the drug is approved, the value of the shares increases to $500,000. Again, for simplicity, let’s assume you sell the stock, your account now holds the $500,000 cash proceeds, and you make no further trades or contributions to the Roth IRA.
On October 1 you also receive a tax-free $28,000 qualified distribution from the Roth IRA to pay the conversion tax (although technically you wouldn’t need to actually pay that tax until April 15, 2016).2 Now your Roth IRA balance is $472,000. Assuming the same 6% earnings rate, after 10 years your IRA would have grown to approximately $845,000–about $200,000 more than if you had not converted–even though tax rates have remained constant and you’ve paid the conversion tax from IRA assets.
There’s no magic to this. You’re simply paying–from the Roth IRA–conversion taxes on the stock before the appreciation, instead of paying taxes on the fully appreciated value of the stock in the traditional IRA at retirement. But by paying the conversion tax from the Roth IRA–instead of from the traditional IRA–you’re able to convert your entire traditional IRA, keeping the funds in the Roth IRA (and potentially benefitting from the hoped-for appreciation) until you actually make a withdrawal from the Roth IRA to pay the tax.
And you can always recharacterize if things go wrong
But what happens if you turn out to be wrong, the FDA does not approve Acme’s drug, and the stock drops to $1? Well, in that case, you can simply undo the conversion. You have until October 15, 2016, to recharacterize the Roth IRA back to a traditional IRA, and for tax purposes you’ll be treated as though the conversion never happened (with no resulting tax bill, or a tax refund if you already paid taxes on the conversion).
Before taking any specific action, be sure to consult with your tax professional.
If you or someone you know is having difficulty paying back student loans, consider investigating the government’s three income-driven repayment plans. These plans–available for federal student loans, not private loans–are designed to make student loan debt more manageable by reducing your monthly payment.
The first and newest program is called Pay As You Earn (PAYE). Under PAYE, borrowers pay 10% of their discretionary income toward their federal student loans each month, and all remaining debt is generally forgiven after 20 years of timely payments. Your monthly loan payment is based on your income, family size, and state of residence. It is readjusted each year based on these criteria.
The second plan is called Income-Based Repayment (IBR), which is similar to Pay As You Earn. Under IBR, borrowers pay 15% of their discretionary income toward their loans each month, and all remaining debt is generally forgiven after 25 years of payments. (For new borrowers who take out loans after July 1, 2014, the IBR terms are the same as PAYE.)
Both PAYE and IBR have an eligibility requirement before you can enter the plan. The payment that you would be required to make under PAYE or IBR (a technical calculation based on your income and family size) must be less than what you would pay under the government’s standard repayment plan, which is a fixed amount over a 10-year term.
The third plan is called Income-Contingent Repayment (ICR). The ICR plan does not have an initial eligibility requirement, so any borrower with eligible loans can make payments under this plan. Under ICR, your payment is equal to the lesser of 20% of your discretionary income or what you would pay under a repayment plan with a fixed payment over a 12-year repayment term. The repayment period is 25 years.
Under all three plans, loans are forgiven after 10 years for those in certain public-service jobs.
The U.S. Department of Education offers a Repayment Estimator calculator on its website www.studentaid.ed.govthat you can use to see whether you qualify for certain plans, and to compare monthly payments and total lifetime costs under different plans.
College is a pivotal time in a young adult’s life. Students gain a sense of independence that is accompanied by responsibility–especially when it comes to finances. If you’re a new college student, it can be overwhelming to figure out how to save and spend money wisely. However, if you take time to plan, you won’t have to worry about spending money carelessly. And your parents will be glad to avoid desperate pleas for cash over the phone.
It may be helpful to review campus resources ahead of time so you can eliminate items that you don’t necessarily need to bring with you to school. Why bring your car and pay for an expensive parking pass if you can use free public transportation? Similarly, it might make more sense to borrow textbooks from your university’s library or rent them rather than fork over the dough to buy pricey books you’ll use for a single semester.
Next, establish a monthly budget. Track your expenses for a month to determine where most of your money is going, then look for the areas where you need to reevaluate your spending. For example, you may be spending too much on take-out when you already have a prepaid meal plan at your school. Take advantage of your plan and put that money toward something else in your budget like clothing or entertainment.
What if you have excess cash? Set aside a few dollars each week to create an emergency fund. Over time, that money could accumulate, and you never know when it might come in handy.
But if you still find yourself strapped for cash, most college campuses offer a variety of part-time jobs that are designed to fit into a student’s busy schedule. Ask about a job the next time you go to the gym for a workout or the dining hall for a meal. Or you can use your school’s career service website to browse work-study options available on campus. As long as you’re aware of what’s available to you, you’ll be better informed to make wise money decisions, which enables you to focus on making the most of this chapter in your academic career.