The Roth IRA is a retirement account created under the Internal Revenue Code. It has some of the very desirable attributes of and differs significantly from the “traditional” IRA. The Roth IRA is funded with after-tax dollars (as opposed to pre-tax dollars which fund the traditional IRA); it has no withdrawal mandate at age 70 1/2 years (as a traditional IRA does); and, best of all, when withdrawals are made from a Roth IRA, they are income-tax free (as opposed to withdrawals from the traditional IRA which are fully income-taxable, since the dollars funding the traditional IRA were invested tax-free).
Until 2010, there were limits on the amount of income a person could earn to qualify to contribute to a Roth IRA; however for the years 2010 and 2011 Congress has removed these limits, and many people are closing down their traditional IRA’s, paying the income tax on the withdrawals, and putting the proceeds into Roth IRA’s.
While many financial advisors are strongly recommending conversion of tradition IRA’s into Roth IRA’s in the two-year “window”, it is something that should be done only after a thorough analysis is made of the consequences. A recent Wall Street Journal article made the following observations:
- The present income tax to be paid could be enormous. If the investor is employed and has substantial income, the withdrawals could be at a very high tax bracket and might push the investor into a higher bracket than he or she is already in.
- Although the Roth IRA’s investment income is not taxable (the same as in a traditional IRA), it could take as much as 15 to 20 years to recoup the income taxes paid on the conversion. (In the meanwhile, the amount paid in tax dollars would have been earning tax-free investment income inside the traditional IRA if it had been left intact.)
- Although one motivation for the conversion is the concern that tax rates are likely to be increased, the increases will probably apply only to the very top brackets and will probably apply only to people earning in excess of $200,000, so that a rate increase will not affect most people. Perhaps more than that, for a person who is presently employed with income taxed in the higher brackets, the tax rate applicable to withdrawals from traditional IRA’s upon retirement could be substantially lower than the rate applicable to withdrawals today to convert to a Roth IRA.
- Although it would depend on each person’s retirement date, if an investor is close to retirement, he or she may have to withdraw from his or her IRA’s for ordinary living expenses; this generally would negate the advantage of a conversion. The conversion makes sense only if the funds are not to be withdrawn for several years. The author of the Journal article estimates that a person should expect to live approximately 15 to 20 years following the date of the conversion to a Roth IRA to justify the move.
Obviously the issues are complex, and if you’re contemplating a conversion, the first thing you must do is sharpen your pencil and do an in-depth analysis. Given the uncertainties (changes in the tax rates, actuarial tables, investment challenges, future family needs, etc.) that accompany your decision, a touch of legerdemain tossed into the mix would help.
— Ken Butera