Articles

To Roth or Not to Roth - that is the question

Written by: Ms. Linda Wong, CFP^®, Edited by: Mr. Kerry Michael Finn, CFP^®

November 15, 2009

"To be, or not to be: that is the question: Whether 'tis nobler in the mind to suffer the slings and arrows of outrageous fortune, Or to take arms against a sea of troubles, And by opposing end them?"

Who knew that William Shakespeare was a Financial Planner? This line is taken from one of the most famous soliloquies in world literature... and yet it expresses the nature of the Roth IRA Conversion Question in 2010.

Perhaps if we change a few words, you will see it more clearly... To convert, or not to convert: that is the question: Is it more fiscally prudent to maintain my tax deferred investment accounts and pay future income tax rates on distributions, Or should I convert to a Roth IRA in 2010, pay my tax now and be free of any future tax levy.

You may have heard from friends, seen it on the news or perhaps even contacted by your financial advisor that many of the restrictions imposed on Roth conversions will be eliminated in 2010.

In the past, and through 2009, the ability to convert a Traditional, Rollover, SEP or Simple IRA to a Roth IRA was limited to single and married filing jointly taxpayers with modified adjusted gross incomes (MAGI) of $100,000 or less (married filing separately taxpayers could not convert at all).

Beginning in 2010; anyone, no matter what their income level or filing status, can convert to a Roth IRA. Some qualified employer retirement plans can also be rolled directly into a Roth IRA if the Plan document allows for the conversion.

These changes apply to Roth conversions only, as the income limitation for annual contributions to a Roth IRA still applies. Additionally, in 2010 only, the income tax liability generated by the conversion can either be recognized on the 2010 tax return, or deferred over the following two years (2011 and 2012 tax years).

Great! Now high income taxpayers can own a Roth IRA and take advantage of tax-free qualified distributions or the ability to leave the assets in the ROTH indefinitely if they choose (Roth Accounts do not have RMDs, required minimum distributions). Everyone should do this, right? Well... maybe, maybe not.

It's actually pretty complicated and the decision to convert to a Roth IRA will depend on several factors such as:

Your Current and Future Tax Position

• The amount converted to a Roth (conversions can be whole or partial) is a taxable distribution from the original IRA and must be recognized as ordinary income on the tax return for the year of conversion (except possibly in 2010 if the income is deferred to 2011 and 2012)
• Federal and possibly state income taxes will have to be paid on the taxable portion of the converted amount
• If you expect your tax rate at the time you start IRA withdrawals to be the same or higher than it is at the time of conversion, then converting to a Roth and paying the lower rate now might be advantageous for you
• You'll also want to be sure to check if the extra conversion income bumps you into a higher tax bracket! To avoid this, a partial conversion can be done for an amount that keeps you in the same tax bracket. If you still want to convert more, it can be done the following year and the year after that, etc.

Your Ability to Pay the Tax Liability from Funds Outside the IRA

• It is extremely important that the funds to pay the tax liability come from a non-qualified account (taxable)
• If you are under age 59 1/2, and you use funds from the conversion to pay the tax, that portion is deemed a non-qualified distribution and will incur the additional 10% early distribution penalty
• Funds withdrawn from a qualified account to pay the conversion tax are not transferred to the Roth to enjoy the potential benefit of several years' tax-free growth
• We advocate using funds from taxable accounts to pay the tax, BUT we do not recommend dipping into funds earmarked for emergencies or soon-to-be-funded goals like college expenses, etc.

Your Individual Time Horizon

• The longer the converted assets are expected to stay in the Roth IRA, the better the case for conversion
• Converted assets must stay in the Roth for 5 years to avoid being subject to income tax and a 10% early withdrawal penalty if you are under 59 1/2
• Your time horizon should also be long enough to at least recoup the taxes paid due to the conversion, and ideally even longer to allow for substantial appreciation that will eventually be withdrawn tax-free

Estate Planning Considerations

• If you are confident that you will be able to fund your retirement completely [with a nice cushion to cover any unexpected expenses] and you want to pass on some of your wealth to your heirs, a Roth Conversion may be a great way to fulfill that goal
• Since Roth accounts do not have RMDs, the converted assets have the opportunity to grow for many more years prior to your death, and be passed on to your heirs who will enjoy tax-free withdrawals (taxes would have to be paid on any appreciation or earnings that occur after the original owners death).
• Additionally, you can think of the conversion tax you pay today as a way of gifting to your heirs without eroding your annual gift tax exclusion or lifetime gifting limits
• The tax paid today is removed from your estate for estate tax purposes and may represent a significant tax savings

Points to Remember

• There is no "rule of thumb" for determining if the Roth Conversion is right for you, seek a trusted financial advisor to evaluate the strategy with you
• Withdrawal of direct contributions to a Roth are tax free, the earnings must observe the 5-Year waiting period for the same treatment
• There is a 5-Year waiting period to access the converted Roth assets, otherwise the distribution is deemed non-qualified and is subject to tax
• If you take a distribution from a Roth prior to age 59 1/2, you may be subject to a 10% penalty
• If you are over 59 1/2 and have aged the Roth assets at least five years, your distributions will be income tax free.

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