The Roth IRA, in which all investment returns can be accumulated tax-free, has in recent years become more widely available to retirement savers. As originally conceived, income limitations made it difficult for those making a good living either to put new money into a Roth IRA or to convert an existing traditional IRA to a Roth.
The log-jam began to break up in earnest with rules that took effect in 2010 eliminating income limitations on Roth conversions, meaning one could convert any amount to a Roth IRA provided one was willing to pay the income taxes generated by the withdrawal from the traditional IRA. The American Taxpayer Relief Act of 2012 (you’ll have to ask Congress exactly why a bill raising taxes for most taxpayers should be called a “relief” act) that was passed shortly after the clock struck midnight on January 1 contains a number of unexpected provisions, some of which ease the rules on Roths further.
My informant in these matters is Ed Slott. You know Ed—he’s the guy you see frequently on public television who, during the first hour of a 90-minute show, tells you over and over he’s going to reveal some really important tips for you, but waits to offer up a chestnut or two until after the third or fourth pledge-break. (Ed does know what he’s talking about—I just wish he’d get to the point.)
Anyway, in a recent article in Financial Planning magazine, Slott points out a number of important provisions in ATRA that changed the 2010 rules. The 2010 rules themselves first allowed 401(k), 403(b) and 457 plans to offer Roth options. For employers who offer this option, each employee can elect whether to defer income into a traditional plan or to contribute to the Roth version. Income deferred to a traditional IRA escapes income taxes in the year earned, but all future withdrawals are subject to tax at ordinary income rates. Conversely, with the Roth option, the employee pays income taxes on contributions in the year the income is earned, but withdrawals are tax-free.
The 2010 rules didn’t permit a participant in one of these plans to convert existing traditional plan assets to the Roth option unless the employee was eligible to take a distribution, limiting the conversion option to those over age 59 1/2. ATRA made in-plan conversions for any participant possible for the first time. Of course, to be able to do an in-plan conversion, the employee must work for an employer whose plan both offers a Roth option and allows in-plan conversions.
Whether it makes sense for those whose plans allow Roth conversions to actually convert their traditional plan to the Roth options depends on many factors. Slott identifies when the employee expects to need to withdraw the funds as particularly important. If it’s relatively soon, the Roth conversion doesn’t make sense. But if the account will be allowed to grow for many years, the conversion should prove beneficial.
A second factor Slott identifies is the source of the money that will be used to pay the taxes. Generally, Roth conversions, whether from a traditional IRA or an in-plan one, make the most sense when the taxes can be paid with funds from outside a tax-deferred source. In effect, the taxes paid from outside represent an additional contribution to the Roth IRA or option. Why so? Suppose you convert $100,000, which increases your state and federal income taxes in the year of conversion by $30,000. If the taxes are paid from the IRA or plan assets, the net increase in one’s Roth account is only $70,000. Paying the taxes from outside assets is really another way of contributing those assets to the Roth IRA.
Slott’s third important factor is one’s expected future tax rate. This is really anybody’s guess. The conventional wisdom when IRAs first became common in the 1980s was that one’s tax rate would be significantly lower in retirement than during one’s working years. From my observation, it rarely works out that way. At least in the first decade of retirement, a retiree’s living expenses are typical at or even above the levels of the later working years. We’re blessed with incredible advances in medical care that allow most retirees to be very active well into their 80s. Income drawn from traditional IRAs and retirement plans to support spending on an active lifestyle is taxed at ordinary income rates, which will typically be higher than the taxes on retirement savings done outside of tax-deferral options such as retirement plans, IRAs and variable annuities.
My firm offers our employees a 401(k) with a Roth option, and I take full advantage of it. Sure, I’m paying income tax on the salary I could put into the traditional option, but both federal and state tax rates have been increasing significantly recently. Despite the record-busting federal budget deficits and the ever-worsening fiscal picture of state and municipal government in California, politicians of all stripes, in an orgy of vote-buying, pander to whatever groups will get them elected and re-elected. I have no illusions that tax rates will be any lower in 10 years, when I may be fully retired, than they are now.
Of course, the great unknown for any Roth IRA or plan option is whether the governments will renege on their Roth promise of “pay the tax now, and avoid the tax later” and make it “pay the tax now, and pay some more tax later.” We’re already hearing trial balloons out of the Obama Administration about limiting the amounts that can be held in traditional IRAs. If you think there won’t be a significant push to tax Roth IRA investment returns within the next 10 or 20 years, you probably think it was the Tooth Fairy that left the quarter under your pillow.
