Talk about money: New rules for 401(k)s can help avoid storm

A major crux of my musings in recent columns has been the copious tax increases that are scheduled for 2011 and beyond. Like a lighthouse on a rocky shore, I have cast a light on the hazards in front of you, giving you ample time to change course and avoid a collision.
Some tax planning can help you successfully navigate your retirement to safer waters, and one technique to help you steer your ship is a Roth IRA conversion.
For those castaways who are easily made seasick, a Roth IRA conversion allows you to leverage low, upfront taxes at today’s rates for a future tax-free income stream. And if you think these tax increases will affect you, this is no tax mirage caused by your delirium.
To illustrate the leverage that can be accomplished through a Roth IRA conversion, let’s look at the example of a hypothetical client: Captain Hook.
Captain Hook is 50 and has a traditional IRA worth $500,000. He is single with a 15-year-old son, Peter Pan. Let’s assume that through pillage and plunder, the Captain does very well for himself, and his booty is taxed this year and in all future years by the fed and state at a combined rate of 42 percent. Let’s further assume that his life expectancy is 80 years and that his account will grow at an annualized rate of 7 percent. (Keep in mind that this is for illustrative purposes only, and individual situations will vary).
When all the taxes are taken into consideration, the Captain will have amassed a total of $2,960,795 by his death at the age of 80 in the year 2040. Had he decided to convert this same account, however, his total would be an even more impressive $4,072,556.
The Roth conversion netted the Captain’s estate an additional $1,111,761 — and remember, this assumes that his tax bracket remains the same. If the Captain were hit with all the new, additional tax increases, the difference in values would even be more dramatic.
Now, assume that Peter Pan inherited this account from his father. Then assume that Peter has matured substantially since his youth and has opted to keep the retirement account intact — taking out only small mandatory distributions over his lifetime (a technique commonly referred to as a “stretch” IRA.) Both accounts would continue to compound at 7 percent. When Peter died at age 83 in 2078, his traditional IRA and other accounts would be worth $7,349,825. However, had the Captain converted his traditional IRA to a Roth IRA this year, the total value at Peter’s death would be $18,411,250. That is an astounding difference of $11,061,425.
You can see the power of time and the tax-free compounding that occurs inside the converted Roth IRA. (Again, this is for illustrative purposes only.)
Let’s say I finally got you excited about a conversion, but all your money was tied up in your employer’s retirement plan, such as a 401(k). Up until now, I have only mentioned Roth IRA conversions, but can 401(k)s be converted to Roths, as well? The answer is no — that is, until a new piece of legislation passes Congress liberalizing rules regarding employer plans and allowing you to convert those accounts, too. The same rules that govern 2010 Roth IRA conversions will also apply here. If you choose, taxable income can be attributed entirely to 2010 or spread over the next two years — 2011 and 2012.
The one caveat here is that your employer needs to offer a Roth 401(k) option to facilitate the conversion. If your employer doesn’t, you should have them speak with us, because there is no good reason they don’t offer this type of account — especially given the rising tide of tax increases.
So, if all these new tax increases are making you seasick, you should consider speaking with your own tax adviser and doing something about it. It could be even more effective than Dramamine.
Orion Melehan is a certified financial planner for LMC Financial Services in Scotts Valley. Contact him at 454-8042 or or***@lm**********.com.
Securities and investment advisory services offered through SagePoint Financial Inc. member FINRA/SIPC a registered investment advisor. LMC Financial Services is not affiliated with SagePoint Financial Inc. or registered as a broker/dealer.