To Roth or Not To Roth

Congress lifted the income ceiling in 2010 for conversion of a traditional IRA to a Roth IRA. So lots of people are wondering if a conversion is a good idea.  The answer is – as it so often the case – that it depends. 

What’s the difference between the two types of IRAs?  Contributions to a traditional IRA might be partially or fully tax deductable, so this type of retirement account has some or all of the balance subject to tax when the money is withdrawn.  Also, with a traditional IRA, you are required to withdraw a portion of the account every year beginning when you turn 70½ and those withdrawals are taxable.  Contributions to a Roth IRA are never tax deductible, but withdrawals aren’t subject to tax.  Also, you are never required to withdraw the money from a Roth.  Both types of IRAs have a 10% penalty if you take money out prior to your age 59½, with a few exceptions. 

Converting from traditional IRA to Roth means that the taxes need to be paid on the taxable portion of the traditional IRA, which sometimes means the entire amount.  During 2010, that converted amount can be taxed partially in 2010 and partially in 2011.  But unless you know you’re going to drop into a lower bracket in 2011 due to a life event – retirement, quitting a job to go to school full time, taking a big pay cut – spreading the tax over two years probably doesn’t make sense.  We know the tax brackets in effect for 2010 and it’s likely that they’ll be higher in 2011.

It’s important to remember that you don’t have to convert your entire IRA.  You could decide to convert just part of it.  So if the top IRS tax bracket you are subject to is 28%, you could convert enough of your IRA to a Roth that you wouldn’t have income pushed into the next tax bracket and leave the rest in your traditional IRA in place.  That Roth balance will now be available in your retirement years to be withdrawn only if you want to withdraw it and will be tax free if you do use it. 

So who is a Roth conversion most appealing to?  If you are in a lower tax bracket this year than normal, you might want to consider it.  Maybe you just retired or you’ve been laid off or had a pay cut in your household.  If you are ten or more years away from retirement and don’t expect your tax bracket to go down much when you leave the workforce, that’s another favorable thing.  So if you’ll have a pension that will pay you when you stop working or your IRA is really large, you might want to look at a conversion.  Ironically, the people who haven’t been eligible this year – high income earners – often have the hardest time justifying a conversion.  I recommend doing a Roth conversion prior to age 59½ only if you have enough cash outside the IRA to pay the tax.  So paying between 28% to 35% to the IRS (on top of any state income tax) to move into a tax free instrument is a difficult pill to swallow at just about any time.  But to do it during a recession when it’s especially important to keep lots of funds liquid in case of a loss of income or another financial emergency is too aggressive for some of these folks.  For people already in retirement, a low stock market can be a good time to do the conversion.  If you account values are down, moving some money to the Roth will allow that money to grow tax free.  Assuming growth on the account of 8%, it takes about three to five years to get back what was paid in taxes.  From then on, all the growth I  the Roth puts you ahead in the tax game on your retirement funds. 

Still undecided?  Make an appointment with a financial planner to see if your particular situation could make sense for a conversion.  Your situation is unique and one of the factors that can’t be quantified is whether or not you’re comfortable with the transaction.

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Revisiting Your Divorce During the Recession

When a divorce is final, the spouses or a third party like a judge or arbiter have made decisions about how assets, debts, and cash flow will be handled.  It’s common to have requirements to sell a home and divide the proceeds, refinance debt to remove one spouse from a loan or credit card, or have alimony (also known as spousal maintenance) paid by the spouse who was the primary earner.  I’ve said that there are few things in life as final as Final Orders in a divorce.  But that’s not always the case.

These “final” decisions are based on many factors – how long a couple was married, what the financial resources are to both parties going forward, and what’s deemed fair in that particular state and courthouse.  These factors usually incorporate what has happened historically in the economy, which is assumed to be a foundation for what will happen in the future. 

In the midst of the worst recession since the Great Depression, some people are exploring reopening their financial settlement.  Maybe the house that was to be sold when the kids moved out is now underwater.  Maybe the credit card to be refinanced can’t be.  Maybe one of the former spouses has lost a job or has had earnings reduced. 

So when is it reasonable to restructure a divorce settlement from several years ago?  Ethical, intelligent people in the family law arena struggle with how to address this in the current environment.  Answers and outcomes vary widely.  There is a long list of considerations, but here are a few.

–         The first and biggest is whether or not the divorce decree allows for changes.  If alimony was part of the settlement and specified as non-modifiable, that is probably not worth pursuing. 

–         If the reasons you want to revisit your settlement are factors that impact your ex as well as you, think carefully about why your divorce would be worth modifying after the fact.  For instance, if your income is down, but your ex has also lost earnings, it might not make sense to revisit alimony.

–         If the factors that negatively impact you are outside the control of your spouse, a judge might not rule in your favor.  For instance, if the house was to be sold and proceeds divided, but more is owed on the house than it would sell for, forcing a sale won’t get either of you a great outcome.  But if the house could be sold for less than originally anticipated and you’d each get some money and you’d now be off the mortgage, that’s worth approaching your ex about.

–         If you want to make a change because you believe in your heart that your long term well being will always be the responsibility of your former spouse, think again.  This is true in any economy.  Unless you are disabled, it’s probably in the best interest of you, your ex, and your kids that you assume that you are responsible for making your financial future a good one.  When people tie their futures to each other through a marriage, they agree to weather storms together.  When they untie their futures through a divorce, they can each assume the autonomy to make their own choices and live with the consequences of their life decisions.  Looking to someone else to solve your problems is seldom healthy emotionally or financially.

Kids in Divorce Recession Style

In any divorce, the children are going to have changes in their lives.  Most parents want to minimize trauma for their kids and have them move forward with the same opportunities available to them when their parents were married.  Realistically, that’s not always possible, whether the economy is good or not. 

Sometimes a parent will intend to sacrifice everything financially for their children.  As noble as this sounds, it might actually do more harm than good to the kids.  If a mom or dad is not able to be financially self-sufficient later in life, the adult children will feel obligated to take care of that parent.   Since the kids probably weren’t old enough to make a life decision like that during the divorce, being saddled with that obligation later in life can be pretty unfair. 

So the best thing each parent can do for the kids is be an excellent role model for financial responsibility and self-sufficiency.  Don’t make financial commitments for activities, trips, and even higher education that you can’t afford.  Young people will learn about the value of moderation and being conscientious if they make some sacrifices during these difficult economic times.  They’ll see the benefits later, even if they don’t now.  It’s also okay to give your kids choices.  If your children are involved with choir, band, soccer, and tennis, but you can’t afford all those after the divorce, let them decide which activities they want.  Also, all of us parents do well to avoid buying affection or trying to assuage emotional trauma with money. 

Another good lesson for kids during the double hit of divorce and recession is that bad times don’t last forever.  The economy will recover.  And they will heal from the sadness of the divorce.  Keep lines of communication open with your kids.  You may also need to keep lines of communication with your ex-spouse open more frequently than you’d anticipated.  You’ll be co-parents for the rest of your lives.  And while the kids are spending lots of time in either of your households, you should endeavor to have some consistency between parents on your financial messages. 

It should go without saying, but don’t put your kids in the middle of disagreements with your ex.  Whether the economy is good or bad, that’s a given.

If you want more on the subject, go to www.brightleitz.com to order a copy of We Need to Talk – Kids & Money After Divorce.

Divorce – Recession Style: Income and Expenses

Divorce is never easy, but add on top of the emotional trauma, the uncertainly of a recession, it gets more difficult.  The next few postings here will deal with some financial issues in divorce and how they’re impacted by our current economic landscape.

If both spouses are able to make ends meet comfortably on what they individually make after a divorce, income doesn’t really come up as a bone of contention.  But if they can’t, then alimony – also called spousal maintenance – becomes an issue.  In divorce cases involving alimony, generally every state looks at the reasonable income of each spouse and their reasonable expenses to figure out what the amount of spousal maintenance might be.  The word reasonable – for both income and expenses – is key.  If I’d like to leave my financial planning firm and try to become an actress, a judge probably isn’t going to require my ex to pay alimony to make that possible.  Also, the courts don’t generally want me to live a substantially better lifestyle than my ex if we’ve been married quite a while.  (All this doesn’t take kids into account.  More on that in a future posting.)  And most people, after a divorce, have to cut back their lifestyles since most marriages don’t have enough excess cash flow to support an entirely separate household. 

So on the earnings side of the equation, in this economy, some people are taking a pay cut or losing their job.  And people entering the work force aren’t having an easy time of it.  Divorce isn’t intended to be a free ride or windfall to either spouse, but courts also don’t want people to have to stay married to survive.  People who aren’t going through divorce are making some temporary compromises in their career paths.  They’re taking a job to get their foot in the door at a company they’d like to work for long term.  Or they’re taking a job they’d otherwise never consider to put food on the table.  So people in the midst of divorce realistically may have to make some of the same choices.  That may lower how much one spouse will pay in alimony, but that certainly doesn’t eliminate the possibility of spousal maintenance being paid.  This may also be a time when people who wanted the security of knowing the amount of alimony was locked into their divorce decree may want the flexibility of having it subject to modification if circumstances substantially change. 

Unreasonable spending levels are one of the factors that caused the recession.  So this is a great time for everyone – in or out of divorce – to get back to sanity in their expenses.  But it should be an equitable approach to cutting back.  It’s not reasonable to have one spouse living in the penthouse with a view of the park while the other is living in a cardboard box in the park.

The Potential of W

Don’t worry.  This isn’t a political posting about our former president. 

Most people expect a recovery from this recession to come in a V shape.  The economy was at a peak, it has fallen into a valley and seems to be heading in a generally upward direction – in other words it looks like the letter V. 

We Americans tend to think about the economy in what I call “The Eternal Now”.  I don’t mean that in a positive metaphysical way of living for the moment.  I mean that we tend to think that whatever is happening now will happen forever. 

When the stock market was booming, people didn’t want to keep any money in safe cash type investments.  They wanted all their money in the stock market where it would – they assumed – always be growing.  People borrowed against the value of their home because the house would be worth more tomorrow than today and they could always just sell it if they needed to.  They paid for everything with a credit card because their income would always go up. 

Sound familiar?  And now too many of the folks who were thinking this way have no money for emergencies, had to sell stock market investments at a low to pay for necessities and can’t pay their mortgages because they lost their job. 

The economy has started a shaky move up, but some of the things that are helping it could cause it to take another sizeable dip before it’s truly recovered.  The government obviously can’t bail out everyone forever.  And the influx of government money in the economy could cause inflation, which could cause another dip in the markets and our general productivity.

So if you’re starting to get back to some of the bad habits that got us into a recession in the first place, stop.  Spend less than you make.  Build up an emergency fund in something really boring like a bank savings account.  Don’t fund your life with debt.  The recovery may look more like a W.  It may go up, then go back down, before it starts a more steady recovery.  Your job isn’t to predict the economy.  Your financial responsibility to yourself is to be prepared if things aren’t smooth in the economy.  Then you’ll be part of the solution, not part of the problem.