While conducting our year end account reviews one of the topics we cover is, if the opportunity is available, should an individual take a distribution from an existing IRA and roll it over to a Roth IRA?
Eligibility to elect a rollover from a traditional IRA to a Roth IRA has been limited to those with an Adjusted Gross Income (AGI) of less than $100,000 – single filers and married filing jointly. This limit has not changed; however, it will be eliminated in 2010.
On Jan. 1 the income cap for conversations will disappear. Those who do convert can elect to split the resulting federal income tax bill (conversion amounts are treated as ordinary distributions) between 2011 and 2012 instead of taking the hit in 2010. If you wish, you can scale back the tax bill by converting only a portion of your traditional IRA holdings to Roth accounts.
Let’s back up and review the principal differences between the two IRA plans.
Created in 1974, the traditional IRA allows qualified income earners to invest a pretax amount each year into an account that grows free of taxes until the funds are paid out in distributions that are taxed as regular income. After you turn 70½, you must begin taking required minimum distributions (RMD’s).
The Roth IRA, in effect since 1998, turned the original concept upside down. Retirement savings contributions come from after-tax money, but your investments grow tax-free and distributions taken after attaining age 59½ are tax-free if you’ve owned the account for at least five years. You are not required to take RMD’s from Roth accounts, so switching traditional IRAs into Roth IRA’s appeals to many investors.
Do you have the money to pay the taxes due on conversion?
In the year you convert, you’ll have to pay the taxes due on the pretax contributions and earnings, preferable without tapping into your IRA money. If you are under age 59 ½, you may also have to pay a 10% penalty. For example, a person with a top marginal bracket of 28% is considering rolling over an existing $100,000 IRA to a Roth IRA. When the $100,000 is distributed, the tax due will be $28,000. If the comparison to the existing $100,000 IRA is made with the Roth IRA starting $72,000 ($100,000 - $28,000), the result will be much different than if the Roth IRA starts even with the traditional IRA at $100,000. In addition, if the $28,000 tax is paid from the distribution amount, the 10% premature withdrawal penalty may be applied to that amount.
If the tax is paid from the proceeds of the IRA being rolled over, a true “apples-to-apples” comparison would start the Roth IRA at $72,000. However, if the assumption is made that the tax will be paid from some other source and the Roth IRA starts out at $100,000, the result will likely favor the Roth IRA. This is true even if a calculation is made to consider the opportunity cost of the dollars being used to pay the $28,000 tax due on the distribution from the original IRA.
Is time on your side?
Do you have enough years between the time you convert and when you retire to allow your new Roth to regenerate the income lost to taxes? The advantage of tax-free distributions from the Roth IRA is leveraged by the length of time the dollars have to grow.
Will you need to take distributions in retirement?
And will your post-retirement tax bracket drop (say from 25 to 15 percent)? If so, converting to a Roth may not make sense because you’ll be paying a lesser rate on your post-retirement traditional IRA distributions than you paid to convert.
Do you plan to leave all your IRA money to heirs?
If so, converting probably makes sense because the Roth IRA doesn’t require your surviving spouse to deplete the funds during your lifetimes by taking RMDs. In essence you are pre-paying the taxes for your heirs.
These days’ people are asking “Will I really be in a lower tax bracket in retirement?” Some important considerations include: What is the likelihood of higher marginal tax rates in the future? Will you continue to work in retirement, or will you even need the income? Evaluating the tax impact of the Roth IRA vs. the traditional IRA depends on the assumptions made.
As you can see, the uncertainty of tax rates in the future makes this comparison increasingly complex. The advantage of rolling over to a Roth IRA generally decreases as the age of the individual increases. Another factor is that, while the individual is alive, the Required Minimum Distribution (RMD) rules have no impact on a Roth IRA.
To summarize, there are many variables in the traditional vs. Roth equation that should be evaluated on a situational basis. There are no simple formulas that spell out a clear decision. An individual’s IRA strategy should be integrated with their overall financial and estate plan to achieve optimal results. For many people, the guidance of a professional financial advisor will be a critical aspect in making the decision that is right for them.
Unless certain criteria are met, Roth IRA owners must be 59½ or older and must have held the IRA for five years before tax-free withdrawals are permitted. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.
Darcie Guerin, financial advisor and branch manager, Raymond James & Associates, Inc. 606 Bald Eagle Drive, Suite 401, Marco Island, FL 34145, provides this article. Gulfshore Life magazine named Guerin as one of the Best Personal Wealth Managers in the Southwest Florida area for 2009. If you have questions, e-mail her at Darcie.Guerin@RaymondJames.com or call 389-1041, toll free (866) 343-0882 or visit RaymondJames.com/Darcie. Past performance may not be indicative of future results.