JANUARY 11, 2010 VOLUME 17, NUMBER 2
Recent changes in federal regulations affecting the Roth IRA now make this retirement savings plan available to wealthier individuals. We list some of the factors to consider in determining whether to convert your existing traditional IRA to a Roth IRA – so that you can discuss the matter in greater detail with your financial advisor.
What are the benefits of a traditional IRA? A traditional IRA allows you to contribute pre-tax dollars to your account. You pay taxes (on the original contribution, plus any increase in value) when you take distributions from the retirement account. The idea is, you will presumably be in a lower tax bracket when you are retired, and taking distributions, than you are as an employed person paying in to the account. The downside to the traditional IRA is that after you reach age 70½, you must take a minimum distribution from the IRA each year. The amount of the distribution is calculated annually and is based on the value of your retirement account and your life expectancy. If you are taking mandatory distributions each year, that will reduce the amount remaining in the account to pass along to your heirs when you die.
(It has long been the case that your spouse can inherit your IRA and continue to take annual distributions based on his or her own life expectancy. Other family members often had to cash out the account in five years, or fewer. Rule changes enacted in 2006 made it easier to pass along the remaining money in your IRA to people other than your spouse – a non-marital partner, or your kids, for example – and allow the beneficiary to take distributions over a longer period of time. See Elder Law Issues November 13, 2006 edition for more detail about those changes).
Why would I want to create a Roth IRA, when I already have a traditional IRA? A Roth IRA is funded with after-tax dollars. This means that as the account increases in value over the years, it increases tax-free. Unlike the traditional IRA, there are no mandatory distribution requirements for the account owner – meaning that more money remains in the account to pass along to your heirs. Although distributions will be mandatory for your heirs, the distributions are tax-free. If you have other sources of income, and you plan to use your retirement account mostly as a vehicle of passing money along to your heirs, rather than to fund your own retirement, a Roth IRA may be preferable to a traditional IRA.
Why are you telling me about a Roth IRA now? Until now, the Roth IRA has only been available to taxpayers whose annual income is less than $100,000. Effective January 1st, taxpayers whose income exceeds $100,000 can convert their traditional IRAs to Roth IRAs. This means having to pay the tax on the account contemporaneously with the conversion. And if you make the conversion in 2010, you can spread out the tax payments over two years.
Why might converting from a traditional IRA to a Roth IRA be a good option?
- If you believe that the income tax rate will only increase in the future, you might decide that it makes sense to pay the tax now, rather than pay it at a higher rate twenty or thirty years down the road.
- If you have sufficient wealth that you don’t think you will drop into a lower tax bracket upon retirement – or if you plan to leave your retirement account to your kids and they will be in a higher tax bracket – it might make sense to pay the tax now.
- If your traditional IRA has suffered a big decline in value over the last couple of years (and whose hasn’t?), you may find it more appealing to convert it to a Roth IRA and pay the tax now, in the hope that the account will increase in value (tax-free) over the coming decades.
You are making a bet, though, that Congress won’t decide to begin taxing the capital gains on the Roth IRA. And, you will need to have money available in order to pay the tax on the conversion – preferably, money coming from a source other than your traditional IRA.
What factors should I consider in making the decision? Here are a few:
- The availability of funds to pay the taxes now;
- Your willingness to pay taxes now, rather than later;
- Whether you are already taking distributions from your IRA;
- When you plan to retire; and
- Whether you intend to live off your retirement account or pass it to heirs.
There are rules about making the conversion (or, having made the conversion, undoing it) and the timing of paying the taxes for the conversion (a lump sum versus installments over two years). There are penalties for withdrawing funds from a Roth IRA within the first five years of establishing an account. For all of these reasons, we encourage you to have a candid conversation with your financial advisor, to see if converting your traditional IRA to a Roth IRA is right for you.