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| Investment Management and Financial Planning |
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Roth IRA’s have long offered investors a great opportunity to grow their wealth in a tax free environment. But, because
Roth IRA contributions are subject to strict income limitations, not everyone gets to benefit from its features. Investors
with traditional IRA’s have also historically been constrained to income limits when converting their IRA into a Roth. The
good news is, as of January 2010, there will no longer be income limitations on eligibility for converting a traditional IRA
to a Roth IRA. Should you consider this, and if so why?
Background
As a refresher, traditional IRAs are funded with pre-tax dollars and defer taxes on investment gains until the day you
withdraw the funds. When funds are withdrawn from the traditional IRA, they are taxed as ordinary income (your highest
tax bracket). Conversely, Roth IRAs, are funded with post-tax dollars but all of the investment earnings grow tax free and
avoid taxes when they are withdrawn (assuming it’s a qualified distribution). Roth IRAs can't be opened by taxpayers
making more than $176,000 (joint returns) and $120,000 for single taxpayers. Furthermore, conversions of traditional
retirement funds into Roth IRAs have not been permitted for households with annual incomes above $100,000.
The Conversion Process
A Roth Conversion is a distribution of assets out of a tax-deferred IRA, such as a Traditional or Rollover IRA, which is
transferred into a Roth IRA. If the converted assets are held in the Roth for the five-year holding period, qualified
withdrawals are tax-free. The conversion from the traditional IRA into the Roth IRA is considered a taxable event, and the
account holder will generally owe taxes on the distribution in the current year. However, in 2010 only, IRA account holders
have the option of applying 50% of the conversion amount to the 2011 tax year and 50% to the 2012 tax year, or applying
100% of the conversion amount to the 2010 tax year. Steep investment losses in many retirement accounts may make
that tax hit easier to take, and will guarantee that any market rebound in investment values will never be taxed if funds are
switched into a Roth account. Finally, conversions must be fully completed by December 31st to qualify for current year
tax treatment.
Why Bother?
So, what makes a Roth IRA so great? If you believe that your tax rates will be higher in retirement than they are now, Roth
IRA’s can save you loads of future taxes—that can translate into greater wealth for you.
Let’s use the following example. You are age 40 and have a $200,000 traditional IRA. Your plan is to retire at 65. Your
current tax bracket is 25% and you anticipate that you will be in (at least) a 30% tax bracket upon retirement. We suppose
that the tax due upon the Roth conversion is $50,000, is paid with funds available outside of the IRA being converted. Let
us also assume an investment tax rate of 15% capital gains rate now and in the future. Using an 8% expected return on
your investments, the after tax net return from your Traditional IRA (with tax savings) would be worth $1,186,411, while the
after tax net return from your Roth IRA would be $1,369,695. That’s a difference of $183,284 by converting to the Roth.
Other Considerations
It is always wise to check with your tax or financial advisor before making a conversion. This is particularly true because
executing a conversion may actually bump you into a higher tax bracket. Because converted assets will be considered
taxable income, perhaps a partial conversion may be the answer. Converting only a portion of the assets may allow you
to stay in a lower tax bracket, allowing you the flexibility to convert additional assets in future years.
Ideally, individuals considering a Roth conversion should have the cash on hand to pay the income tax on converted
assets. A partial conversion could help limit the conversion taxes to an amount your client can pay without dipping into
IRA assets.
Does a Conversion Make Sense for You?
Clearly, everyone’s circumstances are unique and there is no one-size-fits-all answer here. After all, the decision to
convert to a Roth can be influenced by a number of factors including:
• Your age and longevity
• Your income tax bracket now and in the future
• Your expected rate of return
• Your investment tax rate (ie. capital gains rate)
The decision to convert can be complicated. If you want to learn more, Morningstar, has written an informative overview of
the conversion decision, and also provides a useful conversion calculator to help determine if conversion makes sense.
For many, there is no better moment to consider this. The time is right for a Roth conversion.
If you liked this article Buzz it up! Click on the Buzz Up! button below or share it with others by clicking on the share button.
Roth IRA contributions are subject to strict income limitations, not everyone gets to benefit from its features. Investors
with traditional IRA’s have also historically been constrained to income limits when converting their IRA into a Roth. The
good news is, as of January 2010, there will no longer be income limitations on eligibility for converting a traditional IRA
to a Roth IRA. Should you consider this, and if so why?
Background
As a refresher, traditional IRAs are funded with pre-tax dollars and defer taxes on investment gains until the day you
withdraw the funds. When funds are withdrawn from the traditional IRA, they are taxed as ordinary income (your highest
tax bracket). Conversely, Roth IRAs, are funded with post-tax dollars but all of the investment earnings grow tax free and
avoid taxes when they are withdrawn (assuming it’s a qualified distribution). Roth IRAs can't be opened by taxpayers
making more than $176,000 (joint returns) and $120,000 for single taxpayers. Furthermore, conversions of traditional
retirement funds into Roth IRAs have not been permitted for households with annual incomes above $100,000.
The Conversion Process
A Roth Conversion is a distribution of assets out of a tax-deferred IRA, such as a Traditional or Rollover IRA, which is
transferred into a Roth IRA. If the converted assets are held in the Roth for the five-year holding period, qualified
withdrawals are tax-free. The conversion from the traditional IRA into the Roth IRA is considered a taxable event, and the
account holder will generally owe taxes on the distribution in the current year. However, in 2010 only, IRA account holders
have the option of applying 50% of the conversion amount to the 2011 tax year and 50% to the 2012 tax year, or applying
100% of the conversion amount to the 2010 tax year. Steep investment losses in many retirement accounts may make
that tax hit easier to take, and will guarantee that any market rebound in investment values will never be taxed if funds are
switched into a Roth account. Finally, conversions must be fully completed by December 31st to qualify for current year
tax treatment.
Why Bother?
So, what makes a Roth IRA so great? If you believe that your tax rates will be higher in retirement than they are now, Roth
IRA’s can save you loads of future taxes—that can translate into greater wealth for you.
Let’s use the following example. You are age 40 and have a $200,000 traditional IRA. Your plan is to retire at 65. Your
current tax bracket is 25% and you anticipate that you will be in (at least) a 30% tax bracket upon retirement. We suppose
that the tax due upon the Roth conversion is $50,000, is paid with funds available outside of the IRA being converted. Let
us also assume an investment tax rate of 15% capital gains rate now and in the future. Using an 8% expected return on
your investments, the after tax net return from your Traditional IRA (with tax savings) would be worth $1,186,411, while the
after tax net return from your Roth IRA would be $1,369,695. That’s a difference of $183,284 by converting to the Roth.
Other Considerations
It is always wise to check with your tax or financial advisor before making a conversion. This is particularly true because
executing a conversion may actually bump you into a higher tax bracket. Because converted assets will be considered
taxable income, perhaps a partial conversion may be the answer. Converting only a portion of the assets may allow you
to stay in a lower tax bracket, allowing you the flexibility to convert additional assets in future years.
Ideally, individuals considering a Roth conversion should have the cash on hand to pay the income tax on converted
assets. A partial conversion could help limit the conversion taxes to an amount your client can pay without dipping into
IRA assets.
Does a Conversion Make Sense for You?
Clearly, everyone’s circumstances are unique and there is no one-size-fits-all answer here. After all, the decision to
convert to a Roth can be influenced by a number of factors including:
• Your age and longevity
• Your income tax bracket now and in the future
• Your expected rate of return
• Your investment tax rate (ie. capital gains rate)
The decision to convert can be complicated. If you want to learn more, Morningstar, has written an informative overview of
the conversion decision, and also provides a useful conversion calculator to help determine if conversion makes sense.
For many, there is no better moment to consider this. The time is right for a Roth conversion.
If you liked this article Buzz it up! Click on the Buzz Up! button below or share it with others by clicking on the share button.
There May Never Be a Better Time for a Roth Conversion
by Cathy Pareto, MBA, CFP®, AIF® - 2009
by Cathy Pareto, MBA, CFP®, AIF® - 2009
| (c) 2009 Cathy Pareto & Associates, Inc. All rights reserved |
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