Roth IRAs are like regular IRAs in reverse. Regular IRAs give you a deduction when you contribute to them but the proceeds you withdraw from them are taxable. Roth IRAs work the other way around: the contributions to the Roth now are not deductible but the amounts withdrawn from the Roth later (much later and be careful of this) are not taxable at the later date. Since the amounts going into the Roth now will tend to be small compared to the far greater accumulation in later years, if you choose a Roth rather than a regular, you're trading a small tax today for a large tax saving tomorrow.
You may qualify for a Roth IRA conversion which means you take your regular or "classic" IRA and convert it to a Roth. If you do, you will pay tax on the amount converted now, but will not pay tax on the accumulation later. Joe has a regular IRA which has accumulated to $100,000. If he converts it to a Roth this year, he will have an extra $100,000 of income on his tax return this year. If the Roth accumulates to $600,000 in say 20 years, Joe will be able to take out all $600,000 without having to worry about the tax consequences.
If your adjusted gross income is more than $100,000, read no further: you don't qualify for a Roth Conversion. You can only convert your regular IRA to a Roth if your adjusted gross income is $100,000 or less. That $100,000 applies whether you file a joint or a single return. And if you are married filing separately, you cannot convert regardless of income level.
It might appear that if Joe has $1 of other income he is over the $100,000 limit because the Roth conversion will push his gross income up to $100,001. However, this isn't so. The $100,000 limit applies to all other adjusted gross income before figuring the additional income from the Roth conversion.
Let's consider some of the circumstances in which a conversion makes sense.
Jane is 31, a non-smoker and in good health. She will probably live another 50 years. If she has $50,000 in a regular IRA, she should certainly consider a conversion even if she is currently in a substantial tax bracket. Over 50 years the $50,000 is likely to grow to more than $1 million if she lets it accumulate. Yes, it hurts to pay tax on the $50,000 today but it will be nice to be able to use the $1 million or leave it to her children with no tax consequences. Youth and longevity are factors that make the conversion attractive.
Let's suppose that Jane had started a new business in the prior year and has experienced substantial losses in the current year and has discontinued the business. If she has a loss for tax purposes of $50,000 in the current year and little or no other income in the current year, then she can convert without the pain of any tax in the current year. Conversion has to make sense for Jane. Taxpayers with low income years, income so low that they don't, for example, get to use their exemptions and deductions, ought to consider conversions very seriously.
Let's get back to Joe. He would like to convert the $100,000 to a Roth but he is afraid he might have to use $40,000 of it to pay the Federal and state taxes on the additional income in the current year. After the conversion he would only have $60,000 left to accumulate tax free. In effect, the $40,000 that he would have to use to pay taxes - and which would have continued to grow tax free if left in his regular IRA - will no longer be accumulating tax free. That's a negative factor. Joe might consider instead just converting a portion of his regular IRA to a Roth, a portion on which he could pay for the taxes out of funds not accumulating tax free. (Yes, you can convert part of a regular IRA to a Roth without having to convert it all.) Sam, who has a similar $100,000 in a regular IRA, doesn't have Joe's problem. Sam has lots of funds not accumulating in any tax advantaged manner and could use these funds to pay the taxes on the $100,000 of additional income in the current year. Sam would pay the $40,000 out of funds that he has invested at 10 percent and on which he pays tax at a marginal rate of 40 percent. On the $40,000 sent in to pay tax, he will lose $4,000 of income but he won't have to pay tax of $1,600 so that his net loss is only $2,400. All of the $100,000 converted to a Roth, let us suppose, will also be earning ten percent but will not be subject to tax either for the current year or much later when withdrawn. The $40,000 Joe would have to have withdrawn to pay the taxes will be left intact by Sam and the $40,000 part of his conversion will earn $4,000 with no tax consequences either now or later. Funds available to pay the tax on conversion, funds not accumulating in any tax advantaged manner, are a plus for conversion.
From the above discussion, you might assume that Roth conversions should be made by everyone who can make one. Certainly Roths are attractive and certainly many people with substantial regular IRAs should consider a conversion. But not everyone. There are certainly situations where a Roth conversion doesn't make sense.
Heidi is 65 and near her peak earning power. She will pay a combined Federal and state tax of about 30 percent on her income. She has no savings other than a $400,000 College Retirement Equity Fund balance. (Yes, CREFs can be converted first to a regular IRA and then to a Roth so technically, Heidi probably - assume her gross income before considering the conversion is just below $100,000 - qualifies to make a Roth conversion.) Heidi plans to retire in a very few years at which time she is going to use social security and whatever is left of the $400,000 to live out her golden years. Careful Heidi! If you convert now and in full the $400,000 will probably push you up into the top brackets and assume that between Federal and state taxes you are going to say goodbye to 40 percent or $160,000 of that $400,000. Yes the remaining $240,000 will grow substantially over the remaining 20 years of your life but so would the $400,000. And bear in mind Heidi that you wouldn't be anywhere near the top tax brackets in those retirement years if your only income is from social security and from minimum distributions from a regular CREF. If you only have a short remaining life expectancy, if your current tax bracket is substantial but you think your tax bracket after retirement will be low, go slow on making a Roth conversion.
Heidi's friend Jason thinks Roth IRAs are ridiculous. He believes Federal tax rates will go down substantially in the next ten years. His horoscope says there is no way the half dozen major wars America fought in the 20th Century will be repeated in the 21st. We won't win another WWI and WWII. We won't stalemate another Korea and we won't lose another Vietnam and the war on terror may go away.. He believes a biblical passage that the poor will always be with us and he therefore thinks that the most expensive war of all - The War on Poverty - will wind down and be replaced by private charities. He thinks the War on Cancer had good motives but that cancer will be eliminated not by throwing vast sums of money at it but rather by encouraging and recognizing a more gradual approach to cancer research in which we do not spend $1 billion dollars to speed up the victory by one hour. He thinks income taxes in the first half of the 21st Century will decline to what they were in the early part of the 2oth and in fact he is hopeful that the income tax will be replaced by a national sales tax. If you think tax rates are going way down, crunch the numbers before you do a Roth conversion.
In fact, crunching the numbers is desirable in any case if you are considering a conversion from a classic IRA to a Roth. If you're considering a conversion this year, start by estimating this years income and looking up the current marginal tax rate. (Remember, your adjusted gross income this year must be less than $100,000 to qualify for a Roth conversion.) Your marginal tax rate - not your average rate - is what counts; you're deciding whether to add the income from your regular IRA to your other income for the purpose of converting to a Roth IRA. Let's assume the amount you are considering converting is $50,000 and that between Federal and state income taxes, you will have to pay 30 percent tax, or $15,000 on that additional amount of income. Let's suppose you are going to pay the $15,000 out of "other" funds, i.e. funds that are not tax sheltered in some way.
What would have happened to the regular IRA if you had left it alone. Let's suppose you are middle aged and don't plan to retire for another 14 years and let's suppose that at the end of the 14 years you plan to take the amount out of your classic IRA and use it for some extended trips and some high living. (The assumptions being made here are rather extreme and are being made for the purpose of a very simple illustration.) Let's say you think it's reasonable to believe the IRA could earn ten percent a year until retirement. At ten percent your money will approximately double every seven years so that in seven years the $50,000 would have grown to $100,000 and in another seven years it will have further grown to $200,000. You then plan to withdraw it and use it for some high living. You'll have to pay tax on the $200,000 when it's withdrawn and if we assume your marginal tax rate, state and Federal combined, will continue to be 30 percent so that the tax on the $200,000 will be $60,000:
But now let's ask what will have happened to the $50,000 you put into the Roth IRA. If it too is growing at ten percent per year, it too will have grown to $200,000. Unlike the traditional IRA, however, this $200,000 may be withdrawn completely tax free. At this stage it sounds as if the Roth is far better than the traditional: after all, $200,000 is more than $140,000!
But of course there's more to consider. To open the Roth, you had to convert the $50,000 in your traditional IRA to a Roth and that's a taxable event. If the $50,000 of additional income were taxed at 30 percent, you would have paid $15,000 in taxes and we're assuming this comes from outside funds. What would have happened to this $15,000 of outside funds if you had not used it to pay taxes on the Roth conversion? Let's assume it too would have grown at ten percent but since these earnings are taxed (again let's assume a 30 percent tax rate) the net earnings would have been seven percent. At seven percent money roughly doubles in ten years so that the $15,000 would be $30,000. By the end of another four years this $15,000 would have grown - assuming earnings of ten percent and a marginal tax rate of 30 percent - to approximately $39,300. So the $200,000 from the Roth should be reduced by this $39,300 for a net of $160,700.
This $160,700 is still higher than the $140,000 you'd net from your traditional IRA and if our assumptions work out this way, it will prove to have been a good move to convert to the Roth. You're ahead.
Note that longevity generally favors a Roth. If you were to die at the end of one year in the above scenario, the results would not be as favorable for the Roth. The regular IRA would have grown by $5,000 and if the prceeds are now distributed to your beneficiaries and if they pay tax at 30 percent the tax would be $16,500 (or .3 times $55,000 accumulation) for a net of $38,500. The Roth would likewise have grown to $55,000 and wouldn't be taxable. But in the case of the Roth we again must consider the loss of the $15,000 to the IRS to pay the tax on the conversion. This $15,000, if not paid in taxes would have grown by $1,500 but there would have been tax of $450 (or .3 X $1,500) for a net accumulation of $1,050. The "outside" funds thus sacrificed to the IRS would have amounted to $16,050. Subtracting these "lost" funds from the $55,000 leaves a net of $38,950. This $38,950 exceeds the $38,500 from the traditional IRA but only by $450. It bears repeating, longevity favors a Roth. And a short life expectancy reduces and possibly eliminates the advantage of a Roth.
Note that several factors have been swept under the rug in this illustration. We've assumed above, for example, that everything comes to an end when you die but in fact both regular IRAs and Roths can continue for a time with the beneficiary. If, for example, your beneficiary starts taking withdrawals by December 31st of the year following your death, she can spread these payments over her life expectancy. Thus, if your beneficiary is your granddaughter, the funds will grow tax free during your lifetime and will continue to grow tax free during her lifetime! That's a lot of tax free growth. (Careful. If she doesn't start liquidating by December 31 of the year following your death, she has to liquidate the account within five years or face rather stiff penalties.)
It appears from the above example that the Roth always beats the traditional IRA. That's usually true but there are factors that can make the Roth undesirable. If taxes are going way down in the future, the Roth can be a poor choice. It was assumed in the above example that taxes were, are and always will be 30 percent and we assumed that 30 percent even for the year in which the traditional IRA was liquidated at $200,000. Using present tax rates (2006), another $200,000 of income would certainly push you into a higher bracket. Even here, however, one should use pencil and paper and make assumptions about what one thinks will happen in the future.
Let's work out a somewhat more realistic assumption. Assuming she doesn't liquidate her traditional IRA, Joan is in the 33 percent bracket for the current year. She has a $400,000 traditional IRA that she is thinking of converting to a Roth. If she converts, some of that $400,000 will fill up the rest of her 33 percent bracket and much of it will be taxed in the 35 percent bracket. Throwing in state taxes, she thinks it reasonable to believe that she'll be paying about 40 percent on the $400,000. (To do this analysis exactly right, of course, Joan ought to consider the following comparison on two different bases. First, what would happen if she just converts enough of her IRA to fill up the 33 percent bracket; on this basis it will probably pay to convert that large a portion of her IRA. Second, she ought to ask what would happen if she converts the full amount. For the sake of a fairly simple illustration, however, let's assume we're talking about converting the full $400,000 and we believe it reasonable to think that all $400,000 will be subject to a total tax - Federal and state - of 40 percent.) For future years, she thinks her total tax rate, Federal and state, will be only 35 percent. She also believes that, if she does not convert now, thanks to forthcoming declines in her income and the possibility of spreading whatever remains in her traditional IRA over a couple of adjacent years that the marginal tax rate in those years will also be 35 percent.
Consider first what will happen if she does not convert and suppose she expects the traditional IRA to earn about ten percent a year and that she will take out about $40,000 per year (just a little more, perhaps, than her required minimum distribution). The funds withdrawn from the IRA will grow at 6.5 percent per year (or ten percent earnings less a 35 percent tax rate). This table summarizes what will happen with the traditional IRA and the accumulation of her "outside" funds.
| TRADITIONAL IRA | |||||
|---|---|---|---|---|---|
| Time | Earnings | Withdrawal | IRA Balance | Tax | Outside Fds |
| 0 | 400,000 | ||||
| 1 | 40,000 | 40,000 | 400,000 | 14,000 | 26,000 |
| 2 | 40,000 | 40,000 | 400,000 | 14,000 | 53,690 |
| 3 | 40,000 | 40,000 | 400,000 | 14,000 | 83,180 |
| 4 | 40,000 | 40,000 | 400,000 | 14,000 | 114,587 |
| 5 | 40,000 | 40,000 | 400,000 | 14,000 | 148,035 |
Now let's see what would have happened if she had instead withdrawn the funds from her traditional IRA and opened a Roth.
| ROTH IRA | |||
|---|---|---|---|
| Time | Earnings | Roth Balance | "Lost"Funds |
| 0 | 400,000 | ||
| 1 | 40,000 | 440,000 | 160,000 |
| 2 | 44,000 | 484,000 | 170,400 |
| 3 | 48,400 | 532,400 | 181,476 |
| 4 | 53,240 | 585,640 | 193,272 |
| 5 | 58,564 | 644,204 | 205,835 |
Which is better, the traditional IRA, or the Roth? It depends. If she dies at the end of year 5 and all the proceeds and "outside" funds go to her favorite nephew Michael, he will, if she took the Roth approach, receive the balance of the Roth of $644,204 but the other funds he will inherit from her will be reduced by $205,835, the last entry in the second table above. His net is accordingly $438,369.
If she had stayed with her traditional IRA, he would get the outside funds of $148,035 and also the balance in her traditional IRA of $400,000 for a total of $548,035. But the IRA balance of $400,000 hasn't been taxed yet. If the tax on this $400,000 is $109,666, then the $548,035 from the traditional IRA approach will be reduced to $438,369 and we have a "tie" with the Roth $438,369. A tax of $109,666 on $400,000 implies a rate of 27.4 percent. Tax rates will have to go down considerably from their current (year 2006) levels for the traditional IRA to be better than the Roth if she lives five years under this scenario!
What if she dies instead at the end of the first year? Then - assuming the Roth - from the second table we see that Mike would have inherited the balance of $440,000 but the other funds he would have inherited would have been diminished by the $160,000 she would owe on the Roth conversion (see the time 1 row of the second table. His net is $280,000.
Had she chosen to stay with the classic or traditional IRA, he would have inherited the $400,000 balance and the $26,000 of "outside" funds a total of $426,000 but taxes must be paid on the $400,000. From our prior assumption that future tax rates are 35 percent, this tax is $140,000 and reducing the $426,000 by the $140,000 there would be $286,000 left for Mike. This $286,000 exceeds the $280,000 with the Roth and appears to be a better choice in this case. Note, however, the weakness in our assumptions. We assumed Joan's tax on the conversion was at 40 percent in the current year but we have just assumed that in the event of her death the next year the tax rate on the $400,000 coming out of the traditional IRA would be at only 35 percent. If we are still at 40 percent marginal tax, the tax would be $160,000 on the $400,000 leaving only $266,000 for the traditional IRA and again the Roth result would be higher. It's difficult to beat the Roth!
If you would like to play "what if" games and would like a computer to work out the results for you, you might find it interesting to explore one of the several sites that have such program. Try, for example, the TIAA-CREF site. An excellent source for information about the Roth IRA is also www.rothira.com.