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of your traditional retirement plan is that the assets will be taxed at your marginal income tax rate when they are withdrawn during retirement. Roth accounts are an exception to this rule. Roth contributions are made with after-tax dollars, but then no further taxes are applied to these assets while they are growing or upon withdrawal during retirement. Unlike traditional retirement plans, Roth accounts have no required minimum distributions beginning at age 70 ½.
There have been some recent changes in the U.S. tax code that allow more Roth contributions for many investors. Participants in 401(k) and 403(b) plans can now direct some or all of their elective contributions to a Roth account. However, it is up to your employer to implement this change. You have probably 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. 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. As of January 1, 2010, there are no longer any income restrictions on Roth IRA conversions. When you convert assets in a traditional IRA to a Roth IRA, you are required to pay income tax on the amount you convert (minus any after-tax dollars that were contributed to the traditional IRA). In anticipation of a large number of Roth conversions in 2010, the IRS has implemented a one-time option that allows you to pay half the resulting taxes in 2011 and the other half in 2012, rather than having to pay the entire amount in 2011.
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. To streamline this process, the IRS allows you to convert assets from a previous employer's 401(k) or 403(b) plan directly into a Roth IRA, although you will owe taxes on the converted assets.
So how do you decide whether to convert some of your 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 plan to retire within 10 years or less, you may be better off sticking with your 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. It may be prudent 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. There could be an attempt to indirectly tax Roth accounts via the alternative minimum tax. However, the most likely change is higher future income tax rates, which would make Roth assets more desirable. The primary benefit of a Roth account is that it provides some degree of protection from this contingency.
Since future tax laws are unknowable, my recommendation for most people is to hedge their bets and spread their retirement assets among traditional and Roth vehicles. If all your retirement savings are currently under a traditional structure, a Roth conversion for some of your assets may be a reasonable idea. This is a means of reducing risk by diversifying your future tax liabilities.
What about funding a Roth IRA the old-fashioned way, with direct contributions? If your adjusted gross income is less than $159,000 ($101,000 if single), you can deposit up to $5,000 directly into a Roth IRA each year ($6,000 if age 50 or older). If you are ineligible for Roth contributions, you can contribute the same amount to a traditional IRA and convert the assets to a Roth IRA, since there are no longer any income restrictions on Roth conversions. Therefore a married couple can now put $10,000 per year into a Roth IRA, regardless of income. If your IRA contribution is with after-tax dollars and is immediately converted to a Roth IRA, there should be little or no tax liability arising from the conversion. As with any Roth conversion, taxes will be owed on any pre-tax dollars and appreciated earnings converted to Roth assets.
Any time we delve into the U.S. tax code, the details can be a bit mind-numbing. If you have any questions on Roth conversions, I would be happy to address them via telephone or email. Please feel free to contact me at any time.
Jeffrey J. Brown, MD CFA Shearwater Capital
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