Tax season is upon us. There is nothing like the feeling you get when you have finished doing your taxes and you realize you are getting a refund. We all love thinking about what we can do with the money in the weeks or months ahead

Many of you have some kind of retirement account. If you are like many people who watched their account value change in 2008, you are very concerned about how your money is invested. You have to decide how much you need to have in stocks, bonds, or cash. We call this your ‘asset allocation.' There is another component of your retirement plan that is surely as important as your asset allocation, but seldom is considered. I call it your ‘tax allocation.'

In the last article, we discussed the likelihood of dramatically increasing taxes in coming years. Let's start with the assumption that you expect your taxes to increase (I know, that idea may be a real stretch, but work with me for a minute).

What should you do? If you can, consider contributing to a Roth IRA or a Roth 401(k). IRA expert Ed Slott calls it “the best gift the government has ever given to taxpayers.” (Source: The Retirement Time Bomb and How to Diffuse it)

I love a tax deduction – we all do. Millions of Americans save billions of dollars annually by contributing to their employer-ponsored retirement accounts and IRA's and getting a tax deduction for every contribution we make. Could it be that we are shooting ourselves in our collective feet in the long run?

Let me explain.

Imagine you are a farmer in the spring with your newly purchased seed. As you leave your local farm store, you are approached by an IRS agent who makes you an offer, “If you will pay me the taxes on that seed right now, I will let you keep your entire crop, tax-free on your harvest in the fall.” You'd take that deal, wouldn't you?

When you contribute to your Traditional 401(k) or IRA, you are getting a tax deduction now. This, however, ensures that you will pay taxes on your principle and ALL the gains in the future.

When you contribute to a Roth 401(k) or IRA, you forego the deduction on the initial contributions, for the privilege of getting at your money including ALL of the gains in the future income tax-free . If you are not already retired, imagine yourself there. You go to withdraw money from your retirement accounts to supplement your income. Do you care more that you received a deduction on that deposit 20 years ago, or that you can withdraw that money tax-free today? Put another way, is your primary objective in contributing to your retirement plan to create security for your family in retirement, or to get a tax deduction now? If the answer is to create long term security, you should consider foregoing the deduction now and instead contributing to a Roth IRA or a Roth 401(k).

An important point of clarification: you should make sure you take advantage of your employer's 401(k) plan to the degree that they provide matching funds for your contributions. It's pretty hard to beat free money. However, aside from matching funds, your first priority should probably be a Roth IRA or 401(k), not the traditional ones.

You might be thinking “But I will be in a lower tax bracket after I retire, right?”

Not necessarily – think of what is likely to have changed when you retire.

• Most likely your children will have left your home and are no longer a deduction.
• You will no longer be able to contribute to your employer retirement plan and will have lost that deduction.
• Hopefully you will have paid off your home, but as a result you will have lost or reduced any mortgage interest deduction.

Many find their taxes are similar or even higher in retirement because they have lost the biggest tax deductions they enjoyed during their working years.

Quick review on some of the Roth rules:

Contributions

Roth 401(k) – in 2009 you can contribute up to $16,500 on a payroll deduction basis into your account. If you are age 50 or older, you can make an additional $5,500 ‘catch-up' contribution as well. There is no income limit for being eligible to make a Roth 401(k) contribution. Be aware that if your employer matches your contribution, it cannot go into the Roth account, but instead will go into the Traditional 401(k) side.

Roth IRA – In 2009 you can contribute up to $5,000 as long as you have earned income of that amount (wages, not investment income or pension income) or higher. If you are age 50 or older, you can make an additional $1,000 catch-up contribution. You can make a contribution to both a Roth 401(k) and Roth IRA if your income falls within the guidelines. There are some restrictions on Roth IRA contributions:

If you are married and filing jointly, your income must be below $166,000 to make a full contribution, and phases out completely at income above $176,000.

If you are single or file as head of your household, your income must be below $105,000 to make the maximum contribution, and phases out completely over $120,000 of income.

Conversions

If you have an existing IRA or 401(k) from a former employer and you would like to turn it into a tax-free Roth, you may be able to do so. If you try to convert in 2009, your modified adjusted gross income must be below $100,000 this year, and the conversion has to be done before year-end. Beginning in 2010 that restriction goes away, and you can do a conversion regardless of your income level. (Source: Internal Revenue Service)

Be careful with conversions – you don't have to convert all at once, and whatever you convert will show as ordinary income for that tax year. Many people will plan to convert a portion of their accounts each year so they don't have a huge tax bill all at once. A special rule exists for conversions made in 2010 – you can convert what ever amount you like in 2010, and the taxes due from the conversion are stretched out over the next 2 years. The rules for conversions and contributions can be complex, so make sure you consult your tax professional before making decisions.

So let's put the pieces together:

• Our government has habitually been in deficit spending, and that shows no signs of stopping.
• Social Security, Medicare & Medicaid are currently bringing in less than what they need to pay for expected benefits in the future.
• The majority of the baby boomers are still employed, but will be lining up at a rate of 10,000 a day about 120 million of them over the next couple of decades - to get their share of retirement benefits. (Source: Social Security and H.S. Dent Foundation).
• The generation behind them, the “Baby Busters,” are a smaller generation, and will spend less in the economy as a result. This may decrease corporate profits, and reduce tax revenue.
• I believe the government will have to begin curbing benefits, and increasing taxes to deal with this change. The longer they wait to do so, the more dramatic the problems could be.
• The good news: We each have an opportunity to move our own money over to tax-free accounts. I see risk of an increasing “tax-storm” in future years that may be approaching. This strategy allows you to protect yourself by investing those funds where they will have a 0% income tax bracket in the future.

The problem with using Roth IRA's is that it forces us to focus on the long term as we lose the great feeling of a tax deduction now. Ultimately this is likely to be a much greater benefit in the future. It requires us to be more focused on our long-term security than our short-term gratification. It may require a change in our way of thinking about the future.

“The significant problems we have cannot be solved at the same level of thinking with which we created them.”
Albert Einstein

Thom Hall is a registered representative of and offers securities through Securities America, Inc., member FINRA/SIPC. Advisory services are offered through Securities America Advisors, Inc. Securities America and Financial Strategies Institute are not affiliated.

Securities America and its representatives are not tax advisors and do not provide tax advice. The tax information provided here is merely a summary of our understanding and interpretation of some of the current income tax regulations and is not exhaustive. Please consult a tax advisor regarding your personal situation.