IRAs

Is a Roth IRA Right for You?


It has been one of those perverse things. The wealthier you are, the more sense it makes to convert a traditional IRA, where you pay taxes when you withdraw the money, to a Roth IRA, where you pay taxes on money when it goes in. But the rules have only allowed people with modified adjusted gross income no greater than $100,000—those less likely to have big IRAs—to convert a traditional IRA to a Roth. Come 2010, however, the option opens up to everyone. "For 2010 we're going to hire extra analysts to run the numbers," says Christopher Cordaro, a wealth manager with RegentAtlantic Capital in Morristown, N.J.

More than $3 trillion sits in IRA accounts, excluding IRAs that are already Roths. Deciding whether to convert (and how much to convert) is complex. It involves some variables—such as future tax rates—that are unknowable. That, plus the pain of paying taxes now instead of later, may be why many people have been loath to consider conversion in advance of 2010.

But if you have substantial assets—and especially if you want to leave money to the next generation—run the numbers. Online calculators like the one at rothretirement.com can help, but the myriad rules and tax ramifications make talking to an adviser worthwhile. There is an out if you convert and then wish you hadn't—perhaps because your portfolio subsequently shrank as the market fell. The Internal Revenue Service allows you to undo a conversion in a process called "recharacterization."

Here are some guidelines to help you think through the decision.

CASH FOR TAXESWhen you convert a traditional IRA to a Roth, you'll face an immediate tax hit. If you own solely IRAs funded with nondeductible contributions, then you will owe taxes on the earnings only (you paid income tax on the original amount before you set up the account). If you have only IRAs with deductible contributions, then you'll owe taxes on the full amount you want to convert (since you contributed on a pre-tax basis). In that case, your tax hit could be a third of the account's value or higher.

If you contributed both ways, all those assets are considered a lump sum for conversion purposes, and you'll need to figure out the tax implications based on the pro-rata share of each. This prohibits you from cherry-picking among IRA assets to avoid paying taxes on the conversion.

Whatever amount you owe, don't convert if you need to tap tax-deferred savings to pay the taxes. "If you have to use some of that money to pay taxes, this is not a good strategy, and if you are under 59 1/2, it's even worse because you'd pay a penalty [for early withdrawal] just to pay taxes," says Joan Crain, senior director of wealth strategies at BNY Mellon Wealth Management in Fort Lauderdale.

For 2010 only there is an extra loophole: You can choose to postpone the taxes and pay them in two installments over the next two years.

TAX RATE GUESSWORKIf you can pay the taxes on the conversion, the next question is tax rates. One of the big benefits of a Roth is your ability to play your current tax rate off your potential future one: If you expect your rate to be higher in retirement, you can pay the taxes up front at the lower rate. While it's impossible to know what your rate will be in the future, it seems likely it will be higher (at least, in the near future). "A lot of people think they can postpone the taxes until they retire and pay them in a lower tax bracket, but that is not how it is likely to work for a lot of people now," says BNY Mellon's Crain.

There are benefits to conversion even for those whose tax rates remain the same, says T. Rowe Price (TROW) senior financial planner Christine Fahlund. She argues that since you don't know where your tax rate will be in the future, you should think about tax diversification—holding some assets in a regular IRA and some in a Roth—in the same way you'd spread wealth among different asset classes.

You'll want an accountant to calculate the impact of the conversion on your taxes in the year you make the move. For some, the additional taxable income from the conversion could push them into a higher tax bracket or into the Alternative Minimum Tax. That could cause them to lose deductions and pay more overall tax than they otherwise would. If you fall into that category, you may want to hold off or convert only a small piece of your IRA assets in 2010.

THE BIG PAYOFFThe further off retirement is, the more worthwhile the Roth conversion, thanks to the value of tax-free compounding. Similarly, the less likely you are to need the money in retirement, the more valuable the Roth. That's because Roths aren't subject to the rules that force traditional IRA holders to begin drawing down assets at 70 1/2. If you're nearing retirement and haven't saved enough, you're likely better off not converting. But if you can keep your Roth intact in retirement, the power of tax-free compounding is enormous.

The really big payoffs for conversion come to those who hope to leave assets to kids or grandkids. For those worried about the estate tax, the amount you pay in tax on the conversion lowers the value of your future estate (though Roth assets are still included in the estate value). The inheritors will never owe income tax. While there are required minimum distribution rules for inheritors other than a spouse, those amounts are also tax-free. T. Rowe Price ran numbers ("A Tale of Two IRAs", upper right) showing the benefits of converting $25,000 from a traditional IRA to a Roth for a 45-year-old who won't need the money in retirement, and the even-larger benefits for the adult child who inherits that Roth 40 years later. As Fahlund says: "It's a way to leverage that money throughout a family."
Amy feldman photo
Feldman is an associate editor with Bloomberg Businessweek in New York.

Tim Cook's Reboot
LIMITED-TIME OFFER SUBSCRIBE NOW
 
blog comments powered by Disqus