June 19, 2012 — No doubt you have heard about Roth IRAs. But if you are like most people, you are confused about what they are, how they differ from traditional IRAs, and most importantly – whether you should convert some or all of your retirement savings to a Roth. This article will provide you with some background to help you answer those questions, along with 5 possible reasons to consider conversion to a Roth. Please note that this is a complex topic – you should not act without consulting with your financial and/or tax advisor.
Differences between Roth IRAs vs. Traditional IRAs
A key difference between a Roth and a traditional IRA relates to taxes. To the extent allowed by law, a traditional IRA is deductible from current income tax, whereas a Roth is not. When the money comes out, however, the tax advantages swing the other way: principal and earnings in a traditional IRA are taxable, whereas Roth funds are not.
Here are some of the other differences:
Type of IRA
Contribute after age 70.5
Tax Free Withdrawals
Req’d Dist’s at 70.5
Heirs Tax Advant.
* Contributions can be withdrawn tax-free at any time, and earnings can be withdrawn without income tax if the account meets certain requirements
If you have a Traditional IRA or an employer-sponsored retirement plan, now may be a good time to consider converting some or all of those assets to a Roth IRA. A number of reasons to do that are listed below, all of which or course depend on your individual situation.
1. You want to continue contributing to your IRA after age 70.5
With a Traditional IRA, you must stop contributing and start taking minimum distributions from your account at age 70½. Roth IRAs have no such age restrictions: there’s no contribution cutoff, provided income requirements are met, and no rule that you must begin tapping your account at age 70½. Your funds have the potential to grow tax-deferred as long as you want and you gain greater control over your income in retirement. You can tailor withdrawal amounts to your actual income needs—or eliminate them altogether in any given year.
2. You want to leave a lasting financial legacy to your heirs
If you won’t need your IRA to fund your retirement income, a Roth IRA can be an effective wealth planning tool, since heirs can enjoy continued asset growth potential while delaying paying taxes. This works by taking advantage of the fact that beneficiaries of your Roth IRA (other than your spouse) will take annual minimum distributions using their life-expectancy, not yours. This allows more of the funds to remain in the account longer, continually reaping the benefits of tax-deferred growth potential.
3. You’re concerned about taxes
Like diversifying your portfolio by investing in multiple asset classes, you should also consider tax diversification. Combining a tax-free Roth account with a taxable account like a 401(k) or Traditional IRA can give you tax flexibility. This is especially important if you’re concerned about future tax increases or you think that your tax liabilities may be higher in retirement.
4. You think that you might need some of the money before you retire
If you withdraw funds from a Traditional IRA before age 59½, not only will you be taxed on the value of the funds withdrawn, you will also be subject to a 10% early-withdrawal penalty unless an exception applies. With a Roth IRA, you can withdraw the original contribution at any time, without penalty. You can even withdraw earnings, provided you meet certain requirements regarding the length of time held, age and other considerations.
5. You are past age 70½ and would like to quit taking those required minimum distributions
After age 70.5 you may still have the option to convert some or all of your IRA into a Roth, allowing those funds to have the potential to grow tax-free for your own needs later in life or for your heirs. Note that you will need to pay taxes on the taxable amount of the IRA at the time of the conversion, so you should review this option carefully with your tax advisor before electing to convert to a Roth IRA. The funds may only be converted after any current year required minimum distributions have been withdrawn.
If you do convert some of your traditional IRA to a Roth
When you convert from a Traditional IRA or employer-sponsored plan to a Roth IRA, you will incur certain tax liabilities. These include taxes on any pretax contributions plus taxes on any earnings or growth. If you have pre-tax and after-tax funds in a Traditional IRA, there are certain rules that determine how these funds can be converted. Your tax advisor can help you determine which funds can be converted and the amount of taxes due on a conversion.
It’s important to identify funds outside the IRA that can be used to pay the taxes due on the conversion to a Roth IRA. Tapping into the amount converted from a Traditional IRA or employer-sponsored retirement plan to pay taxes will reduce the amount available in the Roth IRA to earn tax free income—and trigger a 10% penalty if you’re under age 59½ (unless an exception to the penalty tax is available).
Get help making your decision
Your financial advisor can help you understand this complex issue better. And, as with all tax related issues, you should also discuss your situation with your tax advisor.
The authors used a helpful backgrounder from the Oakley Wing Group at Morgan Stanley Smith Barney in Essex, CT to develop this article. They are an asset management team who specialize in helping baby boomers coordinate and oversee their financial affairs leading up to and throughout retirement. The team is available to help clients learn more about the preparations necessary to make a financially sound transition into retirement. You can call or email 860-447-4847 or William.firstname.lastname@example.org.
The appropriateness of a particular strategy will depend on an investor’s individual circumstances and objectives. This article is meant to provide background to help you make your own decision – we do not provide tax or legal advice.
Comments? Have you already created or converted to a Roth IRA, or are you considering it? Do you think the advantages outweigh the negatives, or vice versa. Let us know via the Comments section below.