Roth IRAs offer unique features that can make them attractive retirement planning tools. The money you add to the account has already been taxed. But as long as you’re at least 59½ and your account has been open five years or more, you don’t owe federal income tax when you withdraw. In addition, there are no required distributions at 70½ from a Roth IRA, as there are for employer-sponsored retirement savings plans and traditional IRAs.
In other words, adding a Roth IRA lets you build a retirement portfolio that is not only diversified among different stocks, bonds, and other assets, but is also diversified among accounts that are taxed differently. This means you’ll have optimal flexibility to draw down your assets in a way that best meets your financial and tax-planning needs at different stages of your retirement.
WHAT’S NEW AND WHAT’S NOT
One reason you may not already have a Roth IRA is that you may earn too much to contribute. But since January 2010 anyone can convert traditional IRAs or retirement assets in a former employer’s retirement savings plan to a Roth IRA. There are no longer income limits that restrict the conversion option to people with modified adjusted gross incomes (MAGI) of $100,000 or less.
Here’s the rub. Conversions have a price tag. When you convert untaxed contributions and earnings from a traditional IRA or workplace plan, you owe taxes on those amounts. That’s the trade-off for the tax-free withdrawals you can look forward to with a Roth IRA.
BECOMING A CONVERT
Despite the benefits of having a Roth IRA, questions remain. Are you better off paying income tax annually on future withdrawals, as you do with a traditional retirement account? Or is it smarter to pay the tax now so that you can enjoy tax-free withdrawals later? While this is a debate to take up with your investment or tax adviser, there are a few issues that anyone considering a conversion should weigh.
Perhaps the most important is where the tax money will come from. If you’d have to pay the taxes that are due out of the assets you’re converting or other retirement accounts, then it’s almost certainly counterproductive to make the switch. Not only may you owe a penalty on the withdrawal if you’re younger than 59½, but you’ll also be undermining the very reason for making the conversion in the first place, which is to maximize your retirement assets.
Another consideration is whether your tax rate will be higher than it is now after you’ve retired and begun taking withdrawals. Unfortunately, there is no way to know for sure, especially since changes in tax policy are unpredictable. But it is probably fair to say that if you’re several decades from retirement and you’re leaving a job where you’ve had a 401(k) or 403(b), at least considering converting may be smart.
A third, which may be particularly significant if you are approaching retirement age, is whether you will be able to wait five years to take any withdrawals from the Roth account. If you take money out before your account has been open that long, you’ll owe tax on any earnings in addition to the tax you already paid to convert. However, if the account has been open five years but you need money from your converted Roth IRA before you turn 59½, you can withdraw your contributions tax- and penalty-free, since you’ve already paid taxes on the money you moved into the account.
If any of these factors is relevant, you might consider a partial conversion of a portion of your retirement assets rather than converting the full amount. This helps keep the present tax bite more manageable and leaves open the option for future conversions. These might be attractive if your account were to lose value or if your tax rate was lower. In either case the later conversion would cost you less.
THE PRO-RATA RULE
One more point to bear in mind is that you can’t choose to convert only the non-deductible contributions you may have made to an IRA to avoid owing tax. Instead, you must follow the IRS pro-rata rules for conversion, which require that the converted assets must maintain the same ratio of deductible and non-deductible contributions as all of your IRAs — including SIMPLE and SEP IRAs — combined. In a simplified example, if you have a total of $100,000 in IRA assets, of which $20,000 is non-deductible contributions, just 20% of any amount you convert is non-taxable.
This rule is less likely to affect conversions from employer plans, such as 401(k)s and 403(b)s, unless you have made after-tax contributions to your account in addition to pretax contributions. If you have, each employer plan account is considered separately. But to make the smartest choice in this situation, it’s wise to consult your tax adviser.