By SCOTT HANSON
Money Matters
26-OCT-05
Q: I have an IRA account. I am not working right now. Can I roll over my IRA account to a Roth IRA now? If yes, does it mean that I don't need to pay tax at all? _ Clara, Sacramento, Calif.
A: There is no better time to do a Roth conversion than when you are not working or are between jobs. If you play your cards right, you may be able to convert your retirement account with little or no income taxes.
The federal tax code follows a progressive schedule, meaning the more income you have in one year, the higher the percentage of your income will go to taxes.
Due to personal exemptions and standard (or itemized) deductions, some income escapes taxes altogether. Once your income exceeds these exemptions, a small amount is taxed at 10 percent. The rate then bumps to 15 percent, then to 25 percent and so on until the top federal rate caps out at 35 percent.
Because of these progressive tax rates, the better job a person does in saving for retirement, the more the person can wind up giving to the taxman. Think about it. The more a person saves in IRAs, 401(k)s and the like, the higher the tax rate will be. Not so the Roth IRA. Income from a Roth IRA is tax-free.
If you are in a low tax bracket this year because of unemployment, you have the ability to convert some or all of your IRA to a Roth IRA with little or no taxes. You'll have to report the conversion on your income tax return this year, but since you have little other income, your taxes should be minimal. And when you withdraw your Roth IRA during retirement, it will be tax-free.
Anyone who has low income this year but expects to be in a higher tax bracket in the future should seriously consider converting some or all of his or her IRAs to a Roth. The tax savings can be phenomenal.
Q: I am contemplating obtaining a reverse mortgage and would like to know how it might affect my Social Security, Medicare benefits and income taxes. _ Maggie, Elk Grove, Calif.
A: A reverse mortgage is really not that different from a traditional mortgage with the exception of one thing: No payments are made on a reverse mortgage.
Money received from a reverse mortgage, whether it comes in the form of a lump sum or a monthly income, is not taxable to you, nor is it counted as income with regard to Social Security. It has no impact on your retirement benefits, nor does it affect your Medicare benefits.
Because a reverse mortgage does not require monthly interest payments, there is no tax deduction to take. However, once the reverse mortgage is paid off, typically when the home is sold or the homeowner dies, an interest deduction is available.
Q: What are your thoughts on using the new type of option ARM mortgages that require payments of only 1.9 percent fixed for five years? My 40-year-old son is thinking of using one on his home as he is having trouble making his current mortgage payments. His loan is at 3.5 percent fixed for three years, but it is set to go higher real soon. Do you see any trouble with this? _ Connie, Wilmington, Del.
A : I'm not a fan of adjustable-rate mortgages for most Americans, and I'm certainly not fond of the option ARMs that are now common in the marketplace.
An option ARM is a type of loan that allows the borrower to make payments that are less than the interest that is being charged on the loan. For example, the mortgage interest rate may be 6 percent, but the homeowner is required to make payments of only 1.9 percent.
What happens to the other interest? It's added on to the outstanding balance of the loan, creating what is known as "negative amortization."
If your son could continue with option ARMs indefinitely, I'd think they'd be a great choice. But the problem comes when the loan balances grow too high, typically 10 percent to 20 percent higher than the original loan balance. At that time, full interest payments are required, which could double or triple the monthly payment.
My advice for your son? Get a fixed-rate loan on his home now while rates are still low.
(Scott Hanson, CFP, is a senior adviser with Hanson McClain, an investment advisory company and registered principal with Securities America, member NASD/SIPC. E-mail questions to questions@moneymatters.com.)
