Is the Roth right for you?
The buzz in the financial industry right now: Roth IRA conversions. But for most of us, the decision to switch to a Roth will come down to whether we'll be in a higher tax bracket in retirement than we are today. If you think you will be, consider a Roth conversion.
The Baltimore Sun
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The buzz in the financial industry right now: Roth IRA conversions.
Starting this year, there is no longer an income cap to convert a traditional individual retirement account or 401(k) into the tax-friendly Roth. Essentially, everyone now has access to a Roth.
Congress did this to generate tax revenue. Contributions to a traditional IRA and 401(k) are often made with dollars that haven't been taxed yet. When you convert one of those accounts to a Roth, you must pay regular income tax on the amount being converted. Once in the Roth, though, your money and any earnings can be withdrawn tax-free in retirement. You might want to convert to a Roth to leave a tax-free account to heirs, or to diversify your tax situation so at least some of your income won't be subject to taxes when you're retired.
But for most of us, the decision to switch to a Roth will come down to whether we'll be in a higher tax bracket in retirement than we are today. If you think you will be — which is likely the case for younger professionals — consider a Roth conversion.
Financial planners and tax professionals have little doubt that tax rates will go up — so you would be spared having to pay at those higher rates.
"Entitlement programs. Wars. The deficit. Any reasonable person will tell you taxes are going to go up," says Tom Karsten, a financial planner and tax specialist in Fort Worth, Texas.
To help you figure whether to convert and the tax consequences, Fidelity Investments offers an online calculator at fidelity.com/rothevaluator. If it turns out a conversion works for you, here are some mistakes to avoid and strategies to consider:
• Don't tap IRA to pay tax bill.
A conversion can bring a sizable tax bill. And if you don't have the money to pay the bill from sources outside your retirement account, a conversion likely won't make sense. That's particularly true for workers under age 59 1/2 who would be hit with a 10 percent early withdrawal penalty for raiding an IRA to pay the tax bill.
Take the case of a 40-year-old couple earning $110,000 a year and converting $50,000 from a regular IRA to a Roth. Their tax bill at conversion would be $14,875, according to Fidelity's calculator. If they use money outside the IRA to pay that bill, the total value of withdrawals in retirement would be $218,374, assuming they stay in the same tax bracket.
But if they paid the tax plus a penalty out of the IRA, they would have less money to convert. Their total withdrawals in retirement would be $183,666. In fact, they would have been better off not converting at all.
• Don't convert money you need soon.
When you convert to a Roth, you can't tap the account for five years. If you do so and you're under 59 1/2, you will be slapped with a 10 percent penalty, says Joel Dickson, tax specialist with the Vanguard Group.
• Pay now, not later.
For this year only, if you convert to a Roth, you have the option of paying the tax bill over two years on your 2011 and 2012 tax returns. Or, you still can pay on the 2010 return.
Usually, you want to delay paying a tax bill as long as possible, and some recommend doing so in this case, too. They suggest setting aside money to pay the tax in an interest-bearing account until taxes are due.
But there's a risk to waiting. You'll pay taxes based on whatever tax rates are in 2011 and 2012, and the conventional wisdom is the rates will go up after the Bush administration's tax cuts expire at the end of this year. Plus, with interest rates so low now, you're not likely to earn much in interest-bearing accounts.
So, if you have the money on hand, this is one case where it might be better to pay the IRS sooner rather than later.
• Don't convert too much.
The amount you convert will be considered income on your tax return. But if you convert a huge retirement account into a Roth, it's possible that could catapult you into a higher tax bracket, Dickson warns. And the higher your income, the more likely that can happen, he says.
For instance, a married couple with $140,000 in income and converting $50,000 to a Roth would stay in the 28 percent tax bracket, he says. But a couple earning $200,000 and converting $50,000 are pushed up to the 33 percent tax bracket.
However, you could choose to convert just part of either your IRA or 401(k) to avoid a higher bracket.
• Recharacterize a Roth.
If you regret converting to a Roth, you have plenty of time for a do-over. Once you convert, you have until Oct. 15 of the next year to switch back to a traditional IRA and avoid paying taxes on the conversion. It's called a recharacterization.
One reason you would want to do this is if the investments in your Roth plunged after the conversion. Say you convert $200,000 into a Roth, and will owe taxes on that amount. But months later, your Roth investments tank and the account value is cut in half. Rather than pay taxes on $200,000 when the account is now worth $100,000, you can switch back to a traditional IRA and avoid the tax.
You can again convert that regular IRA back into a Roth after a certain amount of time. And if the account value is still down, the tax bill also will be lower than before.
One strategy is to convert your traditional IRA into several Roths, with each containing similar investments, such as corporate bonds in one, international stocks in another, commodities in a third and so on, says James P. Schnell, a partner with the accounting firm of Mengel Metzger Barr & Co. That way, if some investments plummet while others do well, you can recharacterize only the Roths holding securities whose value has dropped, he says.
• Open a traditional IRA.
Even though anyone can now convert a 401(k) or traditional IRA to a Roth, higher income households still can't open a Roth and directly contribute. For 2010, you can make a full or partial contribution to a Roth if income is under $120,000 for singles and $177,000 for married joint filers.
But the conversion opens the back door to the Roth if your income exceeds these limits. All you have to do each year is open a traditional IRA, where there is no income limit if you're not deducting contributions on your tax return. Then, you can turn around and convert that IRA into a Roth. Some say this is a loophole that Congress may close, but others say legislators intentionally created this so higher income taxpayers can access the Roth.
While there's a lot of talk about Roth conversions now, it's not clear how many investors will make the leap even if it would benefit them. The desire to postpone taxes as long as possible is so ingrained that many people won't convert because they don't want to pay the upfront tax bill.
"It's a hard hurdle for a lot of people to get over," Karsten says. "As a practitioner, it's really hard to say, 'Wouldn't you like to pay all these taxes now?' "
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