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Roth Mania!
By Lynn Brenner, March & April 2010
Should you convert your traditional IRA to a Roth IRA? New tax breaks make this appealing—but only if you answer yes to our three key questions
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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.
The Rules
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converted funds can only be withdrawn penalty-free after five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.
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.
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