TheStreet Guest Contributor
By Matthew Malone
NEW YORK (TheStreet) — The apocalyptic talk of the fiscal cliff likely has you worried about your own financial health, particularly your retirement savings, and what you can do before year-end to ease any looming pain. The good news is that there are moves you can make (or not make) to insulate your portfolio from pending tax increases and ward off the more general effects of a neglected retirement account.
Convert to a Roth IRA. A Roth IRA differs from other retirement accounts in that you don’t take a current-year tax deduction for contributions. Instead, you pay income taxes now and don’t pay any taxes when you withdraw money in your retirement years. That’s particular important in an environment like today’s when taxes are set to rise.
For instance, if you’re in the 15% tax bracket this year and convert $1,000 from a traditional to a Roth IRA, you’d pay $150 in taxes on the converted amount. Put the $1,000 in a traditional IRA and you wouldn’t pay anything in taxes today. But what if taxes go up to, say, 20% in the future? If both accounts increased to $2,000 by the time you retire, when you withdraw the money you would pay $400 in taxes with a traditional IRA. With a Roth, you pay nothing but the original $150.
The math improves even more if you consider dividend payments. Today, most dividends are taxed at the long-term capital gains rate of 15%; unless Congress acts, those rates will revert to ordinary income tax rates after Dec. 31. With a Roth, those dividend payments would be sheltered from taxation.
The major caveat to any Roth conversion: Make sure you have the money on hand to cover the tax increase generated by the conversion. Paying penalties for late taxes will very quickly outweigh the benefit of the conversion.
Converting is typically easy. Assuming you meet the Roth IRA income eligibility guidelines, you can usually convert simply by calling your financial institution. The deadline for a conversion for the current tax year is Dec. 31.
Rebalance. the principle behind rebalancing is simple. Over the course of the year, the relative increase and decline in value of your different investments throws your allocation targets out of whack. What started as a mix of 80% stocks and 20% bonds at the beginning of the year could become more like 90/10 or 60/40. To rebalance, simply sell some of the assets that have appreciated and use the money to buy more of assets that have declined (assuming you’re still sure the investment is a good one). Alternatively, a recent Vanguard study suggests a more effective approach is to redirect dividends and interest payments toward purchases that will rebalance the portfolio.
While you can get a higher return by never rebalancing, those modest gains often come with a much higher level of risk. And when you take much higher risks, you should only be satisfied with much higher returns.
Hold off on contributing. It’s not often you’ll hear someone say that holding a pile of excess cash is a good financial decision; this year might be an exception. If you can’t contribute to a Roth, it may make sense to withhold any end-of-year retirement contributions until 2013. With taxes surely to go up, for many Americans the benefit of the corresponding tax deduction will be more valuable next year.
Matthew Malone is managing editor of RothIRA.com, where he is part of a team of editors, writers and technology experts aiming to explain and simplify the complicated world of retirement savings.
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