Jan 11, 2010

Uncle Sam and the Rent-to-Own Scam

Get your Roth IRA today and make no payments until 2011!

Kronk's Shoulder Angels

In the movies you will see the main character facing the dilemma of a lifetime. Suddenly a miniature person will appear on each shoulder. The first will prod her to make all of the wrong decisions while the second character guides her down the straight and narrow.

Occasionally when working with folks, I see this situation playing out as well. However, the shoulder people are a bit different. On the left shoulder is the spender and on the right shoulder is the saver. The spender suggests that you can have everything you want right now; no need to wait. He drags his person into rent-to-own furniture stores and helps them rack up a bill that will destroy their finances for decades. The saver says, “let’s think this through, wait 30 days, and see if you still need that.”

The IRS has offered a so-called ‘break’ for folks converting their Roth IRAs in 2010. They can get their shiny new Roth IRA today, hassle free. Instead of making a big tax payment now, they will make two easy payments in 2011 and 2012.

The side of my financial conscience that encourages me to save shuttered when he heard this. He said to me, “there is something wrong here. Why don’t we check it out?”

Here is the problem. The current taxes are, in many ways, at historical lows. The good news is that the new rates for 2010 are not substantially different than they were for 2009.

The problem comes in 2011 when the EGTRRA (Economic Growth and Tax Relief Reconciliation Act) expires. Tax rates will go back to the rates that were in place before the act was signed into law.

Under current law, a couple who files jointly will have to make $137,300 in order to reach the 28% tax rate. Under the old-school, pre-EGTRRA rules, the same couple would reach the 28% bracket at $43,850. Under the old law, they would reach the highest marginal tax rate (4.6% higher than our current max) at only $288,350, compared to today’s maximum rate which will only affect folks who make more than about $370k.

The saver on my shoulder broke it down so I could understand it. He said that if the folks in Washington didn’t adjust these tax rates, that would mean a much bigger tax bill for some of the folks that convert and put the Roth Conversion tax off. Even if we do see updated tax law, it is doubtful that future rates will be as low as the ones in 2010.

This was not designed to be deceiving; it is simply the perfect storm for the spending side of the financial conscience to wreak havoc on American’s pocketbooks.

The 2010 Roth Conversion Decision is complicated enough. In many cases the theory is sound. There are clear benefits to a Roth Conversion; tax-free growth and no Required Minimum Distributions. When it comes time to write a big check to the U.S. Treasury, things change. It is like taking the step out of a perfectly good airplane, trusting that whoever packed your parachute knew what they were doing.

My concern is that folks will listen to the part of their brain that says, “You need this.” They will give in to the voice calling out, “Buy now and pay later.” They will convert in 2010 but put the tax bill off without considering the consequences.

It goes deeper than just the future tax rates. When you convert a Roth IRA, the Feds will want their cut, but the state will expect their share as well.

Not every state has a rent-to-own program for the Roth Conversion; instead, many states will require that you pay your taxes with your 2010 return. Many of the ‘buy now & pay later’ crowd will be in shock when their state taxes are calculated and they owe the entire state tax in the year of the conversion.

Until we know exactly how the Federal Government will change the rules in coming years, all we can do is make our best guesses and watch out for pitfalls. We could see changes, not only in tax rates, but even in the structure of the different retirement vehicles.

We have seen very few cases (if any) where we thought it was a good idea to convert the entire amount in one year. It is often much more beneficial to convert the amount above your taxable income, up to your next tax bracket. By doing this, you can avoid needlessly leaping up through tax brackets all in one year. This would allow you to pay some of the tax this year and to make a decision whether to convert another portion of your IRA to a Roth in future years based on how the rules have changed.

If you are considering a Roth Conversion, it might be a great idea to gather your accountant, your attorney and your financial planner together to discuss your finances moving forward. Each situation is unique, but these folks can help you determine whether the 2010 Roth Conversion is right for you. They will offer a checks and balances system and help you look for pitfalls.

Consider this a check-up to the saver on your right shoulder. If she doesn’t jump out of her seat when she hears ‘rent-to-own’ or ‘buy now & pay later’, it may be time to have your financial conscience re-calibrated.
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