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by Lynn Brenner, AARP The Magazine, March/April 2010 issue
Are Roth Accounts Right for Me? Read
Is a Roth Right for You? Read
Retirement Account Investments Read
Myth Buster: Too Late to Save Read
Unlike traditional IRAs...
Roth IRAs allow tax-free withdrawals of earnings after you're 59 1/2 and have owned the account for five years (counting from January 1 of the tax year your account was opened).
Roth IRAs let you withdraw direct contributions at any age, without tax or penalty. If you're under 59 1/2, however, converted funds can only be withdrawn penalty-free after five years.
A Roth IRA doesn't require minimum withdrawals after you turn 70 1/2. You can pass the account to your heirs—and they won't owe a penny of tax on it, either. —L.B.
If your banker, broker, or tax adviser hasn't yet pitched you on moving money from your individual retirement account to a Roth IRA, expect a call. As of January 1, anyone, regardless of income, can transfer funds from a traditional IRA, whose withdrawals are taxed, to a Roth, whose withdrawals aren't. A lot of financial pros are eager (maybe too eager) for you to switch, and the government has chipped in with a one-time incentive.
It works like this: if you withdraw money from your IRA to transfer it to a Roth in 2010, you can choose to pay the income taxes on that withdrawal over two years, with the tax returns you'll file for 2011 and 2012. Postponing payment blunts the immediate cost of conversion but carries its own risk—that your income tax rates for those years will turn out to be higher.
While deciding on the wisdom of a Roth retirement account can get complicated, its main selling point is simple: if you follow the rules, your withdrawals will be tax free. With a traditional IRA, by contrast, you pay no income tax on amounts you contribute, but your withdrawals in retirement will be taxable. In effect, the government is your silent partner in a traditional account, its stake in your money growing along with yours. By converting a traditional IRA to a Roth, you buy out that partner and become the sole owner of your nest egg: all its future growth will belong to you.
Some financial gurus believe that Roth conversions are a particularly good opportunity now. Their reasoning is that although taxes may feel high, today's tax rates are historically low, and the government will probably be forced to raise revenue to meet payments on the national debt. "These are the lowest rates most people will see for the rest of their lives," asserts Ed Slott, a Rockville Centre, New York, IRA expert best known for dispensing financial advice on PBS shows such as Stay Rich Forever and Ever.
Three Questions to Ask
Whatever you may hear about the appeal of turning a traditional IRA into a Roth, there's no one-size-fits-all answer. Basically you're determining if you should pay taxes on your nest egg now or later. What's best for you depends on your own tax rate, not rates in general. Your time frame matters, too: a conversion makes sense only if the Roth IRA can grow long enough to make up for the income tax you must pay to create it. That can easily take ten years or more, depending on how your investments fare. But conversion need not be an all-or-nothing proposition. In your 50s, for example, you might put just a piece of your nest egg in a Roth that you earmark for spending tax-free in your 70s or 80s.
Consider a Roth conversion only if you answer yes to these questions:
Is your personal tax rate likely to rise in retirement?
For many people the answer is no. If you're in your late 50s and earn a substantial income, you're in a high tax bracket now, but your rate may decline after you stop working. You don't want to pay hefty taxes now on money you can withdraw less expensively later.
Do you have cash outside the IRA to pay the taxes you'd owe?
You defeat your purpose if you steal from your retirement savings to pay the taxes. Let's say you pay the tax with $25,000 from a $100,000 IRA. That leaves only $75,000 to earn tax-free income in the Roth.
Have you taken care of higher financial priorities?
Consider your entire situation. If your spouse was just laid off or you're still paying tuition bills, don't spend your cash on a Roth conversion. If you're under 59 1/2, you'll pay a 10 percent penalty for withdrawing converted Roth funds within five years of setting up the account.
Crunching the Numbers
Many free online calculators aim to help you gauge the wisdom of a conversion. (One of the easiest to understand is at moneychimp.com.) But you really need a professional's help to make this decision. Online calculators give you at best a rough idea of whether you would come out ahead. At worst they can mislead you, because of their built-in assumptions about essential variables—future rates of inflation, taxation, investment return—and wild cards such as whether you'd invest the tax money you save by not converting, whether you'll make postconversion contributions to the Roth IRA, and whether you'll withdraw your nest egg in a lump sum or (much more likely) in smaller pieces each year.
Yes, it can all be head-spinning, and no online calculator can address individual costs and benefits. The extra income you must declare when moving funds from a traditional IRA to a Roth could temporarily put you in a higher tax bracket, or make you ineligible for tax breaks that phase out as income rises. If you're a Medicare recipient, it could temporarily increase your Medicare Part B premium. Still, the prospect of lowering your future tax bill with a Roth can make these short-term costs worthwhile. And, notes Barry C. Picker, a Brooklyn, New York, tax accountant and leading IRA expert, Roth IRA withdrawals aren't included in the income numbers the IRS uses to determine whether your Social Security check is taxable.
The bottom line: If you're seriously considering a conversion, consult with a certified financial planner or tax accountant. Expect to pay $500 to $2,000, depending on where you live and the size of the firm you use. And don't be dazzled by the 2010 tax break. Despite financial pros' enthusiasm, this isn't your last chance for a Roth conversion. In fact, Picker predicts, many savers will find a gradual approach works best. "For many middle-class people in their 50s, I think it makes more sense to do a series of small annual conversions," he says, to minimize the immediate tax burden. "That's a more affordable way to achieve a meaningful tax-free account in retirement."
Contributing editor Lynn Brenner wrote about getting the most from Social Security in the September-October issue.
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