Beginning January 1, investors will have an expanded option to convert their traditional IRAs and other tax-deferred accounts to a Roth IRA. Should they convert?
The original IRA, often called a traditional IRA, worked on the assumption that it made economic sense to defer tax on earned income during one’s earning years, when most workers are in higher income tax brackets, to one’s retirement years, when tax rates were expected to be lower. Two factors are now likely to upset planning based on that assumption.
Many people already have a substantial portion of their wealth tied up in defined contribution plans and traditional IRAs. When they reach age 70.5, they must begin regular withdrawals from these accounts according to an IRS schedule of “required minimum distributions” (RMD). Failure to withdraw the minimum amount results in a stiff penalty equal to one-half the amount by which withdrawals fall short of the required minimum.
Each year after age 70.5, the percentage of one’s tax-deferred accounts that must be withdrawn increases. A retiree with a combined $1 million balance in tax deferred accounts must withdraw about $36,496 during his first year of RMD, increasing steadily to $53,476 at age 80 and $87,719 at age 90, all of which will be taxed as ordinary income. When added to Social Security benefits and any other taxable income the retiree might be receiving, a retiree with an amount in his tax-deferred accounts adequate to meet his income needs will soon find himself in the higher income brackets—perhaps higher than when he was working.
The second factor that should worry those saving for their own retirement using tax-deferred accounts is that income tax rates in the future may well be much higher than they are today (to pay for today’s government fiscal irresponsibility at both the federal and state level).
Here’s where the Roth IRA comes in. The Roth IRA, authorized by Congress in 1997, turned the traditional IRA on its head. Instead of lowering taxes by deferring current income, one contributes already-taxed income to the Roth IRA. Like the traditional IRA, income and capital gains in the Roth IRA aren’t subject to tax. But unlike the traditional IRA, withdrawals after age 59.5 aren’t subject to tax at either the state or federal level as long as the funds have been held in the Roth IRA for at least five years. And there are no RMD requirements for the original Roth IRA owner.
In some ways, the Roth IRA seems too good to be true. Because tax-free investing with after-tax money is very attractive, Congress has placed many limits on who can make contributions to Roth IRAs. Income limits have also precluded many who wanted to convert a traditional IRA to a Roth IRA from doing so.
But come January 1, the rules will change. Gone will be the income limits on Roth conversions. And those converting in 2010 will be allowed to spread income realized in the conversion over the following two tax years. For example, if you convert $100,000 from a traditional IRA into a Roth IRA in 2010, you’ll recognize $50,000 in taxable income on your 2011 return and a like amount on your 2012 return.
As a general principle, it’s always seemed to me wise to defer paying tax on income as long as possible. However, if one has sufficient savings outside one’s IRAs to pay the taxes resulting from the conversion, converting may be more advantageous. Here’s an example:
Let’s assume you’re age 70 and you have $1 million in IRAs and $450,000 in other already-taxed savings, both of which you intend to use to generate your retirement income. And let’s assume both sources can generate income at a rate of 5 percent annually.
If you withdraw the 5 percent income from both your traditional IRA and your savings, you’ll be able to generate $72,500 in taxable income the first year. Assuming your combined federal and California income tax rate is 40 percent, you’ll pay tax of $29,000, leaving you with $43,500 in after-tax income. If instead you convert your traditional IRA to a Roth in 2010 and use your after-tax savings to pay the income taxes (assumed to be at a 45 percent combined rate), you’ll have a $1 million Roth IRA. Again assuming a 5 percent income rate, you’ll be able to withdraw $50,000 tax-free.
For those already faced with RMD from their IRAs and other tax-deferral plans, the arithmetic in favor of converting improves with age, because the percentage required to withdraw as RMD accelerates over time, reaching 5 percent at age 79, 6 percent at age 83, 7 percent at age 86 and so on. The Roth IRA has no required minimum distributions during the life of the holder. One’s spouse also need take no RMD from an inherited Roth IRA. And one’s children, while they must take annual withdrawals from an inherited Roth IRA based on their life expectancies, also retain the benefit of tax freedom on those withdrawals
Calculating the actual tax impact of conversion is quite complex, particularly if you’ve made after-tax contributions to your traditional IRA, as many have done over the past several years as a way of building up an IRA for eventual conversion to a Roth. So before you seriously consider converting your traditional IRAs or other tax-deferral accounts to a Roth IRA, consult a knowledgeable tax adviser.
