EDITOR'S NOTE: This is a revised version of an article originally published in the December 2009 issue of Kiplinger's Retirement Report. To subscribe, click here.
To Roth or not to Roth? With 2010 around the corner, that’s a question many of you may be asking. Come New Year’s Day, the $100,000 income ceiling to qualify for a Roth IRA conversion finally lifts. But just because you can convert to a Roth IRA doesn’t mean you should.
For retirees and those approaching retirement, the conversion decision hinges on a number of factors: your retirement-income needs, current and future tax bracket, life expectancy and legacy goals. The expected rate of return on your investments will make a difference, too. It is wise to run the numbers to see if converting at least some money to a Roth in 2010 makes sense.
Roth IRAs have attractive features. Roth money can be withdrawn tax-free once certain conditions are met. Plus, account owners never have to take required minimum distributions, so the money can grow in the tax shelter for as long as you choose.
The downside: You have to pay income tax on the amount you convert. Usually, the tax bill comes due in the year of the conversion. In 2010 only, you can delay reporting the conversion for one year, and then split the converted amount in half on your 2011 and 2012 returns, paying part of the tax in 2012 and part in 2013.
When a Roth Conversion Makes Sense
A Roth IRA can be beneficial in the long term because of the power of compounded tax-free growth. The longer you can wait to tap the Roth, the more time the money has to grow tax-free. Converting assets that you won’t need to live on in the early years of retirement is generally more advantageous.
An analysis by T. Rowe Price considered a 65-year-old retiree who has a traditional IRA of $100,000 and $28,750 in a taxable account. All accounts grow at 6% a year. The retiree plans withdrawals of 4% a year, with 3% annual inflation adjustments. The analysis looks at two scenarios: converting and not converting.
If the retiree converts using his taxable account to pay the tax, after ten years the Roth provides about $500 less overall, after taxes, as compared with the nonconversion scenario. Converting is a wash because the Roth hasn’t had much time to grow tax-free. Also, the RMDs from 70 to 75 for the traditional IRA aren’t higher than the planned withdrawals.
But in this analysis, RMDs start to exceed planned withdrawals at age 77. From this age on, the traditional IRA starts to deplete faster than the Roth and converting starts to compare more favorably. By age 95, after taxes, the Roth conversion is worth more than the traditional IRA and taxable account by 10%, or about $27,000. Christine Fahlund, senior financial planner for T. Rowe Price, notes that the age at which the Roth conversion becomes more favorable can vary depending on factors such as tax brackets and market returns.
If you would otherwise be in the same tax bracket or a higher bracket in retirement, a Roth conversion could help keep your future tax liability in check. Roth distributions won’t boost your overall taxable income. Lower taxable income could make you eligible for certain tax breaks that phase out at higher income levels. Also, tax-free Roth distributions don’t count in the equation for taxing Social Security benefits.
For people who don’t need the IRA money to live on, converting can help free your IRA assets from RMDs. Perhaps you have pension payments and only need $10,000 a year in IRA distributions. If your RMD is $15,000, you could convert enough to keep your distribution at $10,000. And that lower RMD could reduce your tax bracket. “With required minimums, people lock into certain tax rates,” says Ken Kilday, a certified financial planner for USAA.
If your potential estate is hovering near the federal estate-tax exemption, converting to a Roth could eliminate or reduce your estate’s tax bill. The money you use to pay income taxes on the conversion will no longer be in your estate and that could help lower your estate below the exemption threshold. (Congress is expected to keep the federal exemption at $3.5 million.)
Heirs can benefit from a conversion in other ways. Although beneficiaries are subject to mandatory distributions on inherited Roths, they don’t have to pay income tax on the withdrawals. “An IRA is like a house with a mortgage. A Roth IRA is a house that’s paid off,” says Kilday.
Heirs can also stretch out the withdrawals from an inherited Roth IRA over their life expectancies. That would let the Roth grow tax-free for decades more.
If you convert early in 2010 and plan to pay the tax in 2012 and 2013, set aside the money in assets that won’t fluctuate much, such as a money-market fund or a fixed-income investment. “That money shouldn’t be invested in stocks,” says Lynn Mayabb, senior managing advisor with BKD Wealth Advisors, in Kansas City, Mo. If the account were to go down in value, you might not have the money when the tax is due.
When Not to Roth
If you plan to donate money from a traditional IRA to a charity, either while you’re alive or as a bequest, do not convert that money to a Roth. You would needlessly pay taxes, with no additional benefit for the charity. The tax bill on a traditional IRA is waived when the money goes to charity.
Also, if your motive for the conversion is to give tax-free money to your heirs, you may not want to convert if the beneficiaries are likely to be in a lower tax bracket when they get the money than you are now. You’ll pay more in taxes to convert than your heirs would have to pay if they inherited a traditional IRA.