Should I Convert to a Roth IRA?
by Ken Morris
Should I Convert to a Roth IRA?
This is a perplexing question many investors are asking
themselves in the wake of all the new tax laws. If the
opportunity is available, should an individual take a
distribution from an existing IRA and roll it over to a Roth
IRA? A good question, but not so fast. The first question should
be; "Can I change to a Roth IRA?"
Eligibility to elect a rollover from a traditional IRA to a Roth
IRA is limited to those with an Adjusted Gross Income (AGI) of
less than $100,000 - single filers and married filing jointly.
There have long been rumblings as to this limit being raised;
however, the limit has not been changed. What has been changed
is how you calculate that $100,000 conversion threshold.
Beginning in 2005, required minimum distributions are no longer
included in countable income for purposes of the conversion
threshold. Thus many more individuals will be able to squeeze
under the $100,000 limitation.
Other individuals will still be excluded from even considering a
Roth rollover. In light of this, individuals with the ability to
do so are likely to manipulate their compensation in 2005 to fit
under the current $100,000 limit. An example of this strategy
might be as simple as deferring a bonus into 2006 or as complex
as restructuring contract agreements. Regardless, the
availability of a Roth rollover must be confirmed before
evaluating the considerations relative to the alternative IRA
OK. Let's say the income limits of the Roth IRA are no problem.
What are some of the considerations in comparing a traditional
IRA to a Roth IRA? Conventional wisdom suggests that most
taxpayers expect to be in a lower tax bracket when they retire.
Financial planning based on this assumption would advise an
individual to defer taxes to the greatest extent possible during
working years, and ultimately pay the tax bill during retirement
at a lower individual rate.
Using this logic, converting to the Roth IRA would appear to be
a less attractive strategy with taxes paid sooner, based on the
individual's current tax bracket. These days, many people are
asking the question; "Will I really be in a lower tax bracket in
retirement?" Some important considerations include: What is the
likelihood of higher marginal tax rates in the future? Will
current deductions for dependents, business expenses and or
mortgage interest offset less income in retirement? Will the
individual continue to work in retirement, or will they even
need the income? Is the objective of the IRA to accumulate
assets for heirs? Evaluating the tax impact of the Roth IRA vs.
the traditional IRA depends on the assumptions made.
Another important consideration in comparing the two
alternatives is the manner in which the tax on the distribution
from the existing IRA will be paid. For example, a person with a
top marginal bracket of 28% is considering rolling over an
existing $100,000 IRA to a Roth IRA. When the $100,000 is
distributed, the tax due will be $28,000. If the comparison to
the existing $100,000 IRA is made with the Roth IRA starting
$72,000 ($100,000 - $28,000), the result will be much different
than if the Roth IRA starts even with the traditional IRA at
$100,000. In addition, if the $28,000 tax is paid from the
distribution amount, the 10% premature withdrawal penalty may be
applied to that amount.
If the tax is paid from the proceeds of the IRA being rolled
over, a true apples-to-apples comparison would start the Roth
IRA at $72,000. However, if the assumption is made that the tax
will be paid from some other source and the Roth IRA starts out
at $100,000, the result will likely favor the Roth IRA. This is
true even if a calculation is made to consider the opportunity
cost of the dollars being used to pay the $28,000 tax due on the
distribution from the original IRA.
There are also several other considerations. The uncertainty of
tax rates in the future makes this comparison increasingly
complex. In addition, the age of the individual electing to roll
over from a traditional IRA to a Roth IRA is important since the
advantage of tax-free distributions from the Roth IRA is
leveraged by the length of time the dollars have to grow. The
advantage of rolling over to a Roth IRA generally decreases as
the age of the individual increases. Another factor is that,
while the individual is alive, the Required Minimum Distribution
(RMD) rules have no impact on a Roth IRA.
In summary, there are many variables in the traditional vs. Roth
equation that should be evaluated on a situational basis. There
are no simple formulas that spell out a clear decision. An
individual's IRA strategy should be integrated with their
overall financial and estate plan to achieve optimal results.
For many people, the guidance of a professional financial
advisor will be a critical aspect in making the decision that is
right for them.
About the author:
"Can somebody please help me watch, manage, invest or oversee my
401k" is the question Mr. Morris hears most often that causes
him the most concern. Fearing the American worker is being left
in the dark, Mr. Morris, a fee based Investment Advisor
Representative, based in Central Ohio, with Raymond James
Financial Services, Inc., helps get the
most out of their retirement.