Much is being written recently about converting retirement funds from a traditional IRA or from a qualified retirement plan such as a 401K plan, 403b plan or 457 plan to a Roth IRA because the ability to convert became available to high income individuals on January 1, 2009, but many hesitate because the conversion requires the payment of income taxes now that could be deferred until later. Tax planning usually means finding a way to defer an income tax liability. However, a good case can be made for paying taxes now to avoid paying more taxes later.
First, let’s compare briefly the advantages of saving for retirement using a traditional IRA or qualified plan with savings using a Roth IRA.
- Contributions to the traditional IRA or qualified plan are deductible in computing your income tax obligation. Contributions to a Roth IRA are not deductible and the conversion or transfer of funds from a traditional IRA or qualified plan to a Roth IRA triggers an income tax liability.
- In both cases the investment account is exempt for income taxes so the income from the investment of the contributions is either tax-deferred in the case of a traditional IRA or qualified plan, or tax-exempt in the case of the Roth IRA.
- Using a traditional IRA or qualified plan you pay taxes when you withdraw the money for retirement or other permitted purposes. The advantage of using a Roth IRA is that distributions from the account for retirement or other permitted purposes are not subject to federal income tax.
- With a traditional retirement account you must commence withdrawals at age 70 ½. A Roth account has no mandatory withdrawal rules. So you can leave the money in the account to accumulate if you don’t need the funds for retirement income.
The deductibility of the contribution was and continues to be a significant incentive to save using a regular IRA or qualified plan. However, the decision to convert from one type of account to another only requires an analysis of the cost to convert versus the tax savings later. One significant factor in that analysis is tax rate at which the distributions from the traditional IRA or qualified plan are calculated. Distributions are added to your other income in the year paid to you and taxed using the graduated rate tax tables. This means that you will pay taxes on the IRA or qualified distribution at your highest personal rate. Here is an example: Carol has an IRA that she used to rollover funds from her 401K at work and she plans to take distributions in 10 years beginning at age 65. She has $500,000 in her account and her distributions. She and her spouse have other taxable income from investments and pensions of $137,000 per year. The incremental tax rate for her retirement distributions (using 2010 federal tax rates) will be 28%. The rate could increase in the future if Congress raises taxes to reduce the deficit. It is worth remembering that in the 1970’s the highest personal rate was 70% and from 1982 until 1987 the highest rate was 50%, but few of us would pay taxes now to avoid the possibility of higher rates later, especially since no one believes that rates could ever be 70% again (could they?).
Now let’s compare the cost to convert in 2010 versus the tax savings later using a Roth IRA. If Carol converts in 2010 she can elect to pay all of the taxes in 2010 or spread the taxes evenly over two years – 2011 and 2012. Carol believes her tax rate will go up in 2011. If she converts in 2010 her tax liability for the conversion will be $500,000 x 28% = $140,000. If she converts she pays no additional tax on the future earnings in the Roth account (it grows taxfree) and there are no taxes to pay on distributions from the account for retirement. Let’s assume that the account grows at the rate of 7% per year whether she converts or not and she takes a full withdrawal at age 65. At a 7% return per year money doubles at that rate in ten years. So after ten years her Roth account will be worth $500,000 – 140,000 = $360,000 x 2 = $720,000 and she can take this at anytime for retirement purposes without incurring a tax liability. Where would she be if she did not convert?
If she did not convert her $500,000 would grow to $1,000,000 in ten years. But any withdrawals for retirement will be subject to income tax. Assume that whether she takes in installments or in a lump sum the additional income will place her in the highest rate bracket. If rates have not increased, her after tax equivalent will be $1,000,000 – [1,000,000 x 28%] = $720,000. She is in the same economic position because the funds grew at the same rate and were subject to tax at the same rate. However, what happens if tax rates go up. If the highest marginal rate goes to 50% she still has $720,000 in the Roth account, but the after tax equivalent in the traditional account is $500,000. So the biggest factor in considering a conversion is future tax rates. If you think they will go up then conversion makes sense.
This example only considers federal tax rates, but one also needs to consider state income taxes. The same rule applies. If you think your tax rate will go up, then conversion makes sense. The tax rate may change if you move from one state to another state before you retire. For example, the State of Florida and the State of New Hampshire have no personal income tax. If you plan to move to a no tax state, your combined federal and state income tax rate may decline or remain the same even if federal rates go up.
The final factor relates to your personal financial circumstances. Will you need the retirement income from the account after you retire? If you will not, then conversion may be advisable even if there is no income tax saving for the simple reason that distributions are required from a traditional IRA or other retirement account beginning at age 70 ½. There is no requirement to take a distribution from a Roth IRA at any age. The amount in the account can be left in the account until you die and the account passes to your heirs.
The analysis is as simple as that!
The result is the same whether you are considering a conversion from a traditional IRA to a Roth IRA, from a traditional rollover IRA to a Roth IRA, from a 401K to a Roth IRA, or from a 401K account to a Roth 401K account.
So why haven’t more people converted? Two good reasons.
First, most people find it hard to part with the tax money now. An account statement that shows you have $1,000,000 looks better than one that shows you only have $720,000.
Second, if you are under age 59 ½ there is a penalty if you use the existing retirement account to pay the taxes. Many just don’t have the financial resources to pay the $140,000 tax obligation without access to the account.
The good news is that you can convert in 2010 and then change your mind until October 15, 2011. You can re-characterize the Roth IRA back to a traditional IRA or change your mind about paying the taxes in 2010 rather than in 2011 and 2012.