Roth Conversions

An inconvenient feature of your traditional retirement plan is that the assets will be taxed at your marginal income tax rate when they are withdrawn during retirement. An exception to this rule is a Roth IRA. Roth contributions are made with after-tax dollars, but then no further taxes are applied to these assets while they are growing within your account or upon withdrawal during retirement. Unlike traditional retirement plans, Roth accounts have no required minimum distributions beginning at age 70 ½. This allows you to leave a larger tax-free gift to your heirs, assuming you have other sources of income during retirement.

There have been some recent changes in the U.S. tax code that allow more Roth contributions for many investors. Beginning in 2006, participants in 401(k) and 403(b) plans were allowed to designate some or all of their elective contributions as Roth contributions. Matching employer contributions can also be placed in a Roth account. However, it is up to your employer to implement this change. You have most likely been notified if you are eligible for Roth contributions. If not, you can check with your employer to see if this option may be offered in the future. Unlike the Roth IRA, participation in a Roth 401(k) or 403(b) is not limited by income.

Another way to increase your Roth assets is to convert a traditional IRA to a Roth IRA. Previously, taxpayers with modified adjusted gross incomes above $100,000 were ineligible for Roth conversions. However, the 2006 Tax Increase Prevention and Reconciliation Act (TIPRA) revokes the income restriction on Roth IRA conversions starting in 2010. When you convert assets in a traditional IRA to a Roth IRA, you are required to pay income tax on the amount you convert. If you participate in a Roth conversion in 2010, you will have the option to pay half the taxes due in 2011 and the other half in 2012.

So how do you decide whether to convert some of you retirement savings to a Roth plan? Unfortunately, there's no way to be absolutely certain about this. In general, you should avoid paying taxes now if they can be put off until later. However, a Roth conversion could be an exception to this rule if your expected future tax savings are sufficiently high. You are most likely to benefit from a Roth conversion if: 1) you are in a high income bracket; 2) you have an investment time horizon of 10 years or more; and 3) you expect future income tax rates to rise. On the other hand, if you expect to be in a lower tax bracket during retirement or you plan to retire within 10 years or less, you may be better off in a traditional retirement plan.

One caveat about Roth conversions: The dollar amount converted to a Roth account is added to your taxable income. A Roth conversion therefore has the potential to push you into a higher tax bracket. If you are considering a Roth conversion in 2010, you may wish to consult your tax accountant to see how much you can convert without increasing your marginal tax rate. Of course, if you're already in the top tax bracket, this is not a concern.

Future changes in U.S. tax laws could impact the appeal of Roth accounts either negatively or positively. In theory, the tax-favored status of these assets could be revoked, but this seems unlikely without grandfathering in tax protection for existing Roth assets. Reduction or elimination of future income tax on withdrawals from traditional retirement accounts would also reduce the attractiveness of Roth accounts. There could be an attempt to indirectly tax Roth accounts via the alternative minimum tax. However, the most likely tax law change - higher future income tax rates - would make Roth assets more desirable. The primary benefit of Roth accounts is that they provide some degree of protection from this contingency.

Since future tax rates are unknowable, my recommendation for most investors is to hedge their bets and spread their retirement assets among traditional and Roth vehicles. If all of your retirement savings are currently under a traditional structure, a Roth conversion in 2010 is probably a reasonable idea.

If you are currently ineligible for a Roth IRA due to income restrictions, you can start building up your traditional IRA assets in preparation for a Roth conversion in 2010. One approach is to make maximum annual contributions to a traditional IRA. If you have any existing assets in a previous employer's retirement plan, these can be rolled over into a traditional IRA without losing any of your tax benefits. All or a portion of these assets can then be converted to a Roth IRA in 2010.

Investing in a tax-smart manner is one of the best ways to maximize your long-term results. This has been known for many years, as illustrated in this quote by a famous American judge from the last century:

"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury…Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands."
-Judge Learned Hand, 1934

Please do not hesitate to contact me if you have any questions or comments.

Jeffrey J. Brown, MD MBA CFA
Shearwater Capital

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