Tax planning and compliance for investors
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Kaye A. Thomas
Updated January 19, 2007
Here are the main advantages of converting a traditional IRA to a Roth IRA.
What's the payoff for converting a traditional IRA to a Roth IRA? How is it that you can end up wealthier by paying tax sooner?
The answer varies depending on your situation. Some people will receive one type of benefit, others will receive a different kind. Some people won't benefit at all. Here's a summary of the benefits of converting.
A Roth IRA is bigger than a traditional IRA that has the same balance. Suppose you have a Roth IRA with a $10,000 balance. If you meet all the rules, you won't pay tax when you withdraw that $10,000, and all the earnings it generates. Compare a traditional IRA with the same balance. When you withdraw that $10,000 you'll pay a fraction of that amount to the IRS. You'll also hand over a fraction of all the earnings. It's as if the IRS owns part of your traditional IRA and gets a share of all the earnings it produces.
The size of the fraction depends on your tax bracket. The higher your tax bracket during the period you make the withdrawals, the smaller your share of the IRA. If your combined federal and state tax rate is 33%, a Roth IRA is effectively 50% larger than a traditional IRA with the same balance!
You won't get the full benefit of the larger Roth IRA if you don't maximize the dollars you contribute. In particular, you'll lose some or all of this benefit if you use money from the IRA to pay the tax on the conversion. For more on this subject, see The Roth IRA Is Bigger.
This is another benefit that can produce huge tax savings and permit you to accumulate much greater wealth in your later years. Rules for the traditional IRA require you to begin receiving minimum distributions when you turn 70½. If you don't need those distributions — perhaps you can live on other savings, or you have a pension in addition to your IRA — the minimum distribution rules serve no purpose other than to reduce your tax benefits from the IRA.
The minimum distribution rules don't apply to a Roth IRA until after the owner dies. A Roth IRA owner who survives well past age 70½ may leave a much greater amount of wealth to children or other beneficiaries as a result of this rule. For this reason, a Roth IRA conversion can pay off handsomely even if you need to use IRA assets to pay the conversion tax and therefore don't get the benefit of having a "larger" IRA as described earlier.
If you have enough wealth to be concerned about the estate tax, you should consider the benefit of a Roth IRA conversion in this connection. The estate tax applies to your total assets at death, including assets held in a traditional IRA or a Roth IRA. The difference is that the estate tax doesn't "notice" that the Roth IRA is bigger. So the amount of estate tax on a $500,000 IRA is the same whether it's a traditional IRA or a Roth IRA.
Consider how this plays out for your beneficiaries. If they receive a traditional IRA, they'll have to pay income tax on the amounts they withdraw. The value of what you transfer to them is reduced by the amount of the taxes. But if they receive a Roth IRA, they get to keep the amounts they withdraw.
What it boils down to is that you've reduced the size of your estate — by prepaying the tax on your IRA — without reducing the value of your estate. Most people don't have enough wealth to be concerned with estate tax. For those who do, the rates are very high, and this benefit of the Roth IRA can be significant.
The fourth possible financial advantage of converting to the Roth IRA is rate shifting. The idea is to pay tax when your rates are low instead of when they are high. This benefit isn't available to most people, and many people will find that rate shifting works to their detriment.
Suppose you're in the 15% tax bracket now, but expect to be in a higher tax bracket when you withdraw money from your IRA. If you convert to a Roth IRA when your tax bracket is low, you'll pay tax at your current, low tax bracket. Later, when you take money out of your Roth IRA, you won't pay any tax, avoiding the higher rates that apply at that time.
This type of thinking makes the Roth IRA seem like a good deal for young people with very low incomes, either because they're still in school or just starting out in their careers. The tax on the conversion is relatively low, and it's very possible that a higher tax will apply later when the money is withdrawn.
The opposite is true for people who are in their prime earning years and expect to be in a lower tax bracket when they're drawing on their IRAs. The difference between the 28% bracket and the 25% bracket isn't enough to worry about in most cases. On the other hand, if you're close to retirement and expect your tax bracket to drop from 25% to 15%, you might think twice about converting now. You'll have to consider whether the other benefits can outweigh this unfavorable rate shift.
Don't place too much emphasis on projections that go far out into the future. In recent decades, tax rates have changed about once every four years. If you're 40 and making assumptions about tax rates when you retire at 66, at best you're making an educated guess.
There's a non-financial benefit of the Roth IRA over the traditional IRA. You have greater flexibility to withdraw money from a Roth IRA before age 59½ without paying penalties. There's no way to place a value on this flexibility, so it doesn't show up in financial projections, but it could turn out to be very valuable.
Bear in mind that this benefit appears only after you've satisfied the five-year requirement for your conversion. For conversions occurring in 2008, for example, the requirement is satisfied on January 1, 2013. Beginning on that date, you can withdraw the conversion amount (plus any regular contributions, but not earnings) without paying any tax or penalty even though you're under 59½.
In recent years the rules for receiving distributions without paying the 10% early distribution penalty have been liberalized. There are a number of situations now where you can use your IRA before age 59½ without paying a penalty, including certain medical expenses, educational expenses and (subject to a $10,000 limit) purchase of your first home. Yet each of these rules comes with various limitations, and there are situations where people have a genuine need for money without qualifying under any of these rules. You're best off if you can avoid using your IRA before retirement, but if you have to tap it, you'll be a lot happier if you can do so without paying a 10% penalty.
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