Roth IRAs

The Roth IRA, a tax-preferenced retirement savings account introduced with the Taxpayer Relief Act of 1997, has been garnering significant media attention, most recently in Kelly Greene’s June 20th article in The Wall Street Journal, Making a Good Deal for Retirement Even Better. Since its introduction the Roth IRA has provided savers an excellent opportunity for socking away funds for retirement and beyond; that opportunity is about to expand for a number of taxpayers.

The Mechanics

You can fund a Roth IRA in two basic ways: via annual contributions (limited to $5,000 in 2009, or $6,000 for those 50 or older) or through a conversion of traditional IRA assets to a Roth. Contributions do not receive up-front tax deductions as they may for traditional IRA contributions and thus are made with after-tax dollars. Conversions entail fast forwarding the taxation of the value of assets moved from a traditional IRA to a Roth IRA.

Growth of assets inside a Roth is tax-deferred, and withdrawals will be tax-free if certain qualifications are met. Beginning on the first day of the fifth year after the Roth IRA was established, and as long as you are over 59 1/2 (or dead, disabled or eligible for the first-time homebuyer exception), withdrawals are completely tax-free. A special rule also deems that withdrawals from a Roth IRA come first from after-tax contributions. Thus at any time you can access your after-tax contributions without tax or penalty.

But the intent of this Viewpoint is not to get mired in the nuances of non-qualified distributions from Roth IRAs, but rather to explain why the Roth IRA can be such a great tool and to provide some framework about deciding whether or not you should be considering a Roth IRA conversion.

Roth Conversion Taxation

Converting assets from a traditional IRA to a Roth IRA involves moving specific investments to the Roth IRA and paying tax on the value of those investments on the date of the transfer. That value will be taxed as ordinary income for federal tax purposes. Since the inception of the Roth, single and joint filing taxpayers have only been allowed to convert if their modified adjusted gross income was less than $100,000 for the year of the conversion. Married filing separate taxpayers can’t convert at all. But as part of the Tax Increase Prevention and Reconciliation Act of 2006, both of the above limitations disappear beginning in 2010, opening the Roth IRA to a whole new group of taxpayers.

The law also provides an additional opportunity, allowing you to report the 2010 conversion amount on your 2010 federal tax return, or alternatively allowing you to spread the taxable amount converted equally across the 2011 and 2012 tax years. Like most aspects of tax planning, whether this opportunity makes sense for you will depend on your specific circumstances and your outlook for future tax rates.

The Benefits of Conversion

Many reasons exist in support of pre-paying tax by executing a Roth IRA conversion, but they all revolve around one simple concept: minimizing tax and maximizing wealth! The best way to enhance the tax-effectiveness of conversions is to pay the tax liability created by the conversion from your other after-tax assets, not from the IRA.

Items to consider when contemplating a conversion:

1. You believe your current tax rate is lower than your future tax rate will be. Whether you expect simply to have a higher income in the future or you expect that future tax brackets will be higher than today, this situation screams for executing a conversion.
2. You believe your current tax rate is equal to or even a little higher than your future tax rate will be. This one catches people because of the common misconception that if current and future tax rates are the same, there is no economic benefit to a Roth conversion as you will have exactly the same future, after-tax value whether or not you convert. That idea only holds if you assume the tax on the conversion is paid from the IRA assets. When other after-tax assets are used instead, a Roth conversion may make sense even if your future tax rate decreases.
3. To become more tax-efficient with regard to required minimum distributions (RMD). The law requires that you take RMD from your traditional IRA upon reaching age 70 1/2; Roth IRAs are not subject to RMD during the owner’s lifetime. A Roth IRA compares favorably to the traditional IRA in this respect because the traditional IRA loses the growth opportunity on the taxes paid on your RMD. Over time the cumulative benefit of the more tax-efficient Roth can become significant. Also keep in mind that if you have large balances in your traditional IRA and/or 401(k), your future RMDs could potentially kick you into higher tax brackets on their own.
4. You would like to better your tax diversification. As a hedge against the uncertainty of your future situation asset values, spending needs and tax rates ensuring that you have funds available in a tax-free bucket may provide you greater flexibility to be more tax-efficient with meeting your living expenses.
5. When you have a taxable estate situation. In certain circumstances, net wealth may be enhanced by incurring an income tax via a Roth conversion before incurring an estate tax. Whether this can benefit you depends on several variables including but not limited to the size of your estate, the tax diversification of your assets and the estate and income tax laws of your state.
6. When you intend to leave assets to your children. A Roth IRA is an excellent asset to leave to a child. Though beneficiaries who inherit Roth IRAs must begin taking required minimum distributions, the accounts can still continue to grow tax-free over the childs lifetime.

Other Strategies to Consider

If you anticipate your 2009 MAGI will be less than $100,000, you may want to execute a conversion today in light of today’s lower market values as this equates to lower taxes and increases the likelihood of the benefit of a conversion paying off sooner than it otherwise would.

Whether you can convert now or have to sit tight until next year, don’t pass up the opportunity to execute smaller tactical conversions – perhaps amounts that bring you to the top of the 15% or even the 25% income tax bracket. While we have no idea what our tax system may look like ten to fifteen years from now, it’s probably a safe bet that rates won’t be lower than today’s 15% bracket; do a conversion and use up the lower brackets!

Next Steps

A Roth IRA conversion will not make sense for everyone. And there are many intricacies we haven’t covered here that can simplify or complicate the decision to convert. If you would like to discuss the pros and cons of a Roth IRA conversion, please do not hesitate to contact us.

If you have any questions, please don’t hesitate to contact us. If you’re not currently a client, but would like to schedule an appointment, please contact Lisa Reynolds at (513) 792-6648 or l.reynolds@truepoint.devphase.io.