Should you join the Roth conversion parade?
Posted on 12 August 2009
Permanent URL of this article: http://retirementrevised.com/money/should-you-join-the-roth-conversion-parade
Get ready for a big push from the mutual fund industry this fall urging you to convert your traditional tax-sheltered retirement account to a Roth IRA. The inspiration for the marketing drumbeat is a change in federal law next year that lifts the household income limit for eligibility to convert traditional IRAs to Roth accounts.
Marketing hype aside, retirement investors should give serious consideration to the opportunity to convert some portion of their savings to a Roth. Tax-deferred investing is an essential part of any retirement savings plan — but it’s not the complete answer. Withdrawals from tax-sheltered accounts can have negative consequences for your overall tax situation in retirement, since your brackets can be somewhat fluid after you stop working. Sometimes, taking a distribution from a tax-deferred account can put you into a higher bracket than you want to be in, boosting your tax bill.
With a Roth IRA, you’ve paid the income tax upfront, since you invested post-tax dollars. That means your withdrawals are tax-free, so long as the account has been open five years and you are at least 59-1/2 years old.
Roth IRAs, with a few exceptions, grow income tax free and owners are not required to begin taking minimum distributions at age 70-1/2. While you don’t receive the tax deduction of a traditional IRA at the time of your initial investment, your Roth IRA can continue to grow tax-free for as long as you own it.
By contrast, with a traditional IRA, you’ll pay taxes on both the original investment and any growth when the money is withdrawn. Unless you expect your tax bracket to be lower later on, you’ll reap a substantial benefit from the tax-free growth of a Roth.
Another major Roth benefit is withdrawal flexibility. Unlike traditional IRAs, you aren’t required to take annual distributions from a Roth when you turn 70-1/2. That makes Roths a good vehicle for intergenerational wealth transfer, as you can simply bequeath holdings to your heirs as tax-free income. But your heirs generally will have to take minimum payouts from the inherited Roth over their lifetimes.
Younger people typically open Roths early in their investing careers, but for people closer to retirement, it’s more often a question of converting. That’s where the upcoming change in the law comes into play. Currently, you can convert to a Roth only if your household modified adjusted gross income is $100,000 or less. But come January 2010, that limit is eliminated altogether.
Now for a couple of caveats:
–Immediate tax liability: A Roth isn’t right for every investor, since you need to be able to fund the tax liability generated by moving your funds out of a tax sheltered account. Consider this carefully before doing a conversion, and only convert the portion that you’re sure you can fund. Ironically, one positive here is the depressed condition of most retirement portfolios. Shrunken asset values actually make this a great time to move dollars out of traditional tax-sheltered IRAs to taxable Roth IRAs; the value of the funds you move is taxable now–which means you can more easily move a greater amount of equity value.
–Future tax policy: When you convert to a Roth, you’re making a bet of sorts on future federal tax policy that might–or might not–work in your favor. Some financial planners are cautioning investors not to put too big a bet on Roths given the ballooning federal deficit and looming pressure on spending from rising federal expenses for programs like Medicare, Social Security and health care reform. Some worry that Washington might try to raise revenue by pulling the rug out from Roths’ tax-free status, or subject them to capital gains taxes.
But at the end of the day, it’s impossible to make investing decisions today based on changes in policy that might occur. So, don’t put all your eggs in one basket; rather, it’s best to employ a balanced mix of tax-deferred and taxable retirement accounts. Against that background, Roths can play an invaluable role–and the 2010 conversion opportunity is a good one.
Read previous coverage of Roth IRAs here.
