Understanding Roth IRA conversions
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Everyone looks for ways to save money, and to make their money work harder - and longer. With pensions disappearing and reductions in employer match programs, it is important for Americans to consider financial planning tools that address long-term retirement and tax situations. One such tool is the Roth IRA.
A traditional IRA permits before-tax contributions which enjoy tax-deferred earnings. A Roth IRA, however, only allows after-tax contributions, but can provide income-tax-free earnings for retirement and is not subject to required distributions that apply to a traditional IRA. First introduced in 1997, changes in the tax law effective this year now make Roth IRAs more broadly available.
"Starting this year, Americans can, for the first time, convert a regular IRA to a Roth IRA regardless of income level. For many, it is an opportunity to invest money in one of these tax-advantaged retirement savings accounts," explains Robert Fishbein, vice president and corporate counsel for Prudential Financial. Remember that you do need to hold the Roth for five years to qualify for tax free treatment, Fishbein says, and if you need to access the funds before those five years and you are not age 59 1/2 or older, then a penalty tax may apply on amounts withdrawn.
For those considering a Roth conversion, Fishbein provides answers to some commonly asked questions.
1. Do I need to hold my Roth IRA for a long period of time for it to make sense to convert?
In most cases, no. If you think your income tax rates will be the same or higher in retirement, you do not have to hold the Roth for any period of time for the conversion to make sense. Given scheduled tax rate increases, this may be the situation for many retirees. If you think your income tax rates will be lower in retirement, then you may need to hold the Roth for a period of time before you make money or it pays economically to have it converted.
2. Do I have to do a complicated financial analysis to determine if a Roth conversion makes sense for me?
Only if you think rates will be lower when you take distributions from the Roth IRA. If you do think you will be paying tax at lower rates in the future, then your financial advisor can help you determine how long you will need to hold the Roth IRA for it to make sense for you to convert. The point in time when it becomes profitable for you to have it converted is sometimes referred to as the "crossover point." In general, though, if retirement is many years away, a Roth conversion may well make sense even if you are going to pay tax at conversion at a rate higher than what you will pay in retirement at distribution.
3. My tax rates will be lower in retirement so I should not convert to a Roth IRA.
This is a common belief, but many modern retirees are working and have some wage income and, with Social Security and distributions from other retirement assets, are actually in the same or a higher tax bracket. Also, given current budget deficits and the cost of funding future Social Security and Medicare payments and the new health care legislation, tax rates may be headed up.
4. I will not be eligible for loans or financial aid for my child's college education.
It is true that converting to a Roth may raise your income level in the year of conversion and reduce eligibility for college loans. However, unless you convert over a period of years, this would be a one-year impact and needs to be considered as a factor in the conversion analysis. It should not be seen as a deal breaker.
5. Will it increase the tax on my Social Security benefit and increase my Medicare Part B premium?
Like the financial aid concern, the increased income from the Roth conversion could make more of your Social Security benefit subject to income tax and it could increase your Medicare Part B premium (now means tested). But these should be one year impacts and should simply be factored into the Roth conversion analysis. These should not be deal breakers. Indeed, you may pay less tax on your Social Security benefit or less Medicare Part B premium in the future since Roth distributions are not included in the applicable calculations.
6. Paying taxes to the government early is bad tax planning.
Usually it is bad tax planning to pay your taxes early and, in effect, make an interest free loan to the government. But the rules may be different now that tax rates could be headed up. By choosing not to pay the tax now, you may also be choosing to pay the tax later at a higher rate (remember, someone will eventually pay income tax on the IRA earnings, either you or your spouse or your children). Now might be a great time to pay taxes at the lower rates and avoid the rate increases on the horizon. If you cannot overcome your emotional hesitancy here, then consider converting some of your IRA or over a period of years.
Of course, a financial planner is best suited to guide you with decisions regarding your own personal circumstances.
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