Taxes are the key difference between Roth accounts and traditional tax-deferred retirement accounts. With a Roth account, taxpayers make after-tax contributions that can grow and compound tax-free. Regular IRAs involve contributions that may or may not be deductible for the taxpayer, depending on their tax bracket. Participants in a traditional 401k plan make pre-tax contributions to their accounts. Upon distribution from a tax-deferred account, all appreciation and any pre-tax contributions are subject to tax at then-prevailing ordinary income tax rates. In addition, regular IRAs and 401k accounts require the account holder to take minimum distributions beginning at age 70 ½. Roth accounts have no such requirement. Any distribution you elect to receive will be free of tax in most instances. According to the IRS: Unlike a traditional IRA, you cannot deduct contributions to a Roth IRA. But, if you satisfy the requirements, qualified distributions (defined in Publication 590) are tax-free. Contributions can be made to your Roth IRA after you reach age 70 1/2 and you can leave amounts in your Roth IRA as long as you live. The rules for a Roth 401k option are similar. With these differences in mind, consider these five factors when evaluating traditional and ROTH accounts:
- Roth accounts accelerate taxes. If you contribute to a Roth directly or through Roth conversion, you will owe income tax on the contributed amounts in the current tax year. If you have been contributing to a regular 401k, your taxes will likely rise when you start contributing to the Roth, since your gross income will increase. Similarly, with a Roth conversion the value of the converted assets will be subject to ordinary income tax (with a few exceptions) in the year of conversion. One issue to keep in mind: if your personal taxes are likely to change significantly in the future, either because you will be in a new tax bracket or due to changes in the tax code, then you should consider the timing of your Roth conversion so as to reduce your tax liability.
- Current year IRA contributions may be converted. If you do not already have an Individual Retirement Account, but are otherwise eligible to make regular IRA contributions, you may establish an account before April 15th and fund it with your contributions for both 2011 and 2012. You may then immediately convert the traditional IRA to a Roth IRA. Depending on your tax status, you may elect to make a non-deductible contribution in order to accelerate your tax liability. Opinion: Immediate conversion offers a means for higher-income taxpayers to effectively make Roth contributions without regard to the income limit.
- Non-deductible IRA contributions are not subject to tax at the time of conversion. If your individual retirement accounts consist entirely of non-deductible contributions (i.e. contributions for which you did not claim any prior tax deduction) and earnings thereon, then you will not owe tax on the aggregate contribution amount upon conversion to a Roth, because the tax has already been paid. However, you will owe tax on any appreciation in the account. If you have both pre-tax and after-tax accounts (including, for example, IRA rollovers from 401k, 403b, or other qualified plans), you are not allowed to cherry-pick accounts for conversion. The tax on any converted amounts will be based upon an IRS formula that considers the value of any account (or part thereof) upon which tax has not already been paid. Opinion: Roth conversion may be especially attractive for individuals whose IRAs consist primarily of after-tax contributions, since there would not be much tax owed as a result of conversion and the account would subsequently be shielded from tax. Note that the amount of tax owed as a result of Roth conversion will be dependent on your income (before the effect of conversion), your marginal tax rate, the total value of all Roth conversions effected by you during the tax year, the value of IRAs that have not been converted, and the ratio of after-tax IRA contributions to overall account values, among other factors. The specific tax rules are complex and you are advised to consult your financial advisor and/or tax accountant regarding the tax implications of conversion, given your personal circumstances.
- Partial Roth conversions and partial Roth contributions are permitted. You are permitted to convert all or part of one or more individual retirement accounts to a Roth IRA. Similarly, most 401k plans will allow you to make both pre-tax contributions and after-tax contributions to Roth, subject to the statutory contribution limits that apply across all accounts. Opinion: Depending on your marginal tax rate, the composition of your overall investment portfolio, including the value of investments held in taxable accounts, and your time horizon, a partial conversion may be the most effective way to minimize your overall tax liability.
- Roth accounts require no minimum distributions while you are alive. Unlike traditional IRAs and 401k plan accounts, which require minimum distributions beginning at age 70 ½, there are no required minimum distributions with Roth accounts. Opinion: if you do not have any need to draw upon your retirement savings, Roth accounts offer both an investment benefit and an estate planning benefit. Your Roth accounts may grow and compound on a tax-free basis over your entire lifetime. Moreover, since taxes are paid at the time of contribution or conversion, as the case may be, Roth accounts provide an additional estate planning benefit by reducing the size of your taxable estate and eliminating the double taxation that might otherwise occur.
One important consideration that should be noted by anyone considering a Roth account, and especially by anyone considering Roth conversion: taxes resulting from Roth conversion should be paid from a taxable account. In using regular, taxable savings or income to pay the taxes, taxpayers are effectively able to gross-up the value of their tax-advantaged accounts by the amount of taxes paid. I invite you to try the Roth Conversion Calculator we have developed to help you assess the impact of Roth conversion given different assumptions about your investment portfolio, future investment returns and tax rates.
Please note that all of the information presented herein is for educational purposes, is general in nature, and may not be appropriate for you. It should not be relied upon or construed as financial, legal, or tax advice or recommendations. You should speak with your financial advisor for assistance in evaluating the risks and benefits of Roth accounts and Roth conversion given your particular financial circumstances, or you are welcome to contact the author for a free consultation.
An earlier version of this article was first produced in 2011 and published on the North Capital blog. James P. Dowd, CFA, is the principal of North Capital, a fee-only registered investment advisor.