Guest column: New year is a good time to consider adding Roth IRA to financial strategy
Jan 25th, 2010 by Afiya
JIM SANDAGER IS SENIOR VICE PRESIDENT, FINANCIAL ADVISER, OF WEALTH ENHANCEMENT GROUP AND HOST OF “YOUR MONEY” ON WHO-AM (1040) RADIO. • JANUARY 24, 2010
The new year rings in a new financial planning strategy that could be right for many people: Roth IRAs.
Previously, Roth individual retirement accounts were a tool only available to those who earned less than $100,000 annually, but now with the Tax Increase Prevention and Reconciliation Act of 2005, or TIPRA, everyone is able to participate.
Roth IRAs can play an important role in retirement and estate planning because they are a tax-free growth vehicle, and there are no required minimum distributions.
Investors should be cautious when using this tool, since the decision to convert a traditional IRA or eligible employer retirement plan to a Roth IRA can be complex.
Ten questions that might arise when considering a conversion:
Q. Which qualified assets can be converted?
A. A taxpayer may convert any assets in traditional IRAs and other plans such as 401(k) and 403(b)s, SEP IRA/SIMPLE IRAs and governmental 457 plans.
Q. Is there a limit on how much I can convert?
A. There is no minimum or maximum amount.
Q. What types of implications will there be if I convert?
A. When converting to a Roth IRA, the taxpayer must pay the taxes tied to his current income bracket. Paying these taxes can be a big hurdle.
One benefit of converting in 2010 is that there is a special tax consideration: The taxpayer can elect to defer taxes on the conversion into 2011 and/or 2012.
If he elects to defer taxes until 2011 and 2012, the amount of tax owed will be based on his income and tax rates for those years.
Also, be aware that by converting too much to a Roth IRA, a person can increase his taxable Social Security benefits, increase Medicare premiums and reduce eligibility for financial aid.
Be sure to consider all the effects a conversion could have on income. Because there may be hidden tax or other implications, it is wise to seek professional help to identify the benefits and consequences.
Q. Should I convert to a Roth IRA?
A. It is a difficult decision. Unfortunately, it’s not as easy as using a break-even calculator to identify if a conversion is right. The decision should consider the whole financial picture.
Converting to a Roth IRA may be beneficial if one or more of the following points is true- There is enough money outside the IRA or employer plan to pay taxes.
- The taxpayer expects to be in the same or higher tax bracket at retirement. Consideration should be given should there be a temporary decrease in taxable income or a temporary increase in tax deductions.
- There is a significant time period before the assets are needed.
- There is a significant proportion of tax-deferred assets, such as a 401(k) plan, relative to tax-advantaged assets.
Q. How does a Roth conversion help with estate planning?
A. A Roth conversion can reduce a taxable estate.
This can be advantageous in certain situations. Because the funds in a Roth IRA grow tax-free, the Roth can grow for generations and provide a great tool for heirs.
Non-spouse beneficiaries must take distributions, but generally, they are tax-free and can be spread over the course of their lives. Some benefits are more advantageous to specific individuals than others.
Q. Am I too old to benefit from a Roth conversion?
A. While age is a factor that a Roth analysis should cover, there are potential benefits that are unique to each taxpayer. Specifically, older individuals might be more interested in a Roth conversion because it allows for legacy planning benefits.
Q. What if the Roth IRA value significantly increases or decreases when I convert?
A. If the value goes up, the tax on the conversion will have been calculated on a lower value. This is one of the advantages of converting.
If the value goes down, a taxpayer can “re-characterize” the Roth IRA to a traditional IRA. This must be done by the due date for filing the income tax return.
Q. What if Congress changes the rules?
A. That is a possibility, but participants will likely be grandfathered in. Although there are no guarantees, this is typically what occurs when changes are made to the tax code.
Q. A general rule has always been to defer paying taxes for as long as possible. Why doesn’t a Roth conversion follow that reasoning?
A. This is the first time that taxpayers in the higher brackets can take advantage of the tax-free benefits of a Roth IRA. This is one tool that can be used to diversify retirement accounts.
Q. Because future tax rates are unpredictable, how can I know if converting will benefit me?
A. Just as diversification is used to deal with the uncertainty of investments, it can be a good idea to have at least some money in Roth IRAs to diversify exposure to income taxes.
A Roth IRA can help a taxpayer control when and how much income taxes are paid. For instance, if a taxpayer only has tax-deferred assets for retirement, he may have to withdraw more money from those accounts to pay the taxes on the money withdrawn.
Then, the taxpayer has to pay taxes on the money he withdrew to pay the taxes. Tax-free Roth IRA withdrawals help a person regain control of this situation.
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