Taxes going up? Time to Roth!
Milton Friedman (famous economist) once said humorously, “Congress can raise taxes because it can persuade a sizable fraction of the populace that somebody else will pay”. Guess what? You’re the “somebody else”. The present condition of our government and state of politics leads to one certainty – “higher taxes”. In that vein, perhaps it’s time to revisit a retirement strategy for those that expect to pay higher taxes.
The Roth IRA is not a new strategy, but it may be the timeliest since its creation in 1998. Since its origin there have been many revisions to the rules regarding who, when and how much can be contributed to a Roth. For purposes of this article, we’ll focus on the benefits of using a Roth IRA vs. a traditional IRA. Many 401(k) plans now allow for Roth contributions and have many of the same benefits as a Roth IRA. Speak to your benefits coordinator for more information on your specific company’s plan.
So what’s so great about a Roth IRA? Tax-free compounding that’s what! In a nutshell, a Roth requires you to pay taxes now, but all future growth on your money is tax-free. Sounds to good to be true, well it depends on your tax situation. If you think that your effective tax rate is lower now than when you pull the money out later, a Roth IRA just might be for you.
Not everyone can contribute to a Roth IRA, but don’t fret because you still may be able to convert. A maximum $5,000 contribution per year ($6,000 over age 50) can be made to a Roth IRA by married individuals with adjusted gross income (AGI) up to $169,000 ($107,000 for single filers). The contribution is completely phased-out at $179,000 ($122,000 for single filers). But there is no restriction on who can convert an IRA to a Roth IRA. Rule changes in 2005 permanently eliminated income limits on those who can and cannot convert to a Roth IRA. However, before you make the move, be sure you understand all the rules associated with a conversion and that you’ve discussed the conversion with your tax advisor.
Let’s look at an example. Assume that your family’s (joint) AGI is $200,000 for 2011, thereby eliminating your ability to contribute to a Roth IRA.However, assume you contributed $45,000 of after-tax dollars over the years to a traditional IRA that has now grown to $150,000 (you have a $45,000 cost basis). If you think that your current federal tax rate of 28% is lower than the 33% rate you will pay 15 years from now, then what should you do? At a 6.4% annual investment return, your traditional IRA will continue to grow tax-deferred until you begin to make distributions. The after-tax value of your traditional IRA will be $269,703 in 15 years (assuming no more contributions). However, if you convert to a Roth IRA today you will need to include the $105,000 tax-deferred portion of your IRA ($150,000 minus $45,000) into your 2011 taxable income. Even so, your converted Roth IRA 15 years from now will have a value of $304,828 (more than the traditional IRA). (This analysis assumes no state tax or alternative minimum tax (AMT) and that taxes due from conversion will be paid from assets outside the IRA. It further assumes that you are over age 59 ½, so there is no 10% pre-mature withdrawal penalty.) A Roth conversion does not need to occur all in one year. It may make sense to convert your IRA over a series of years to minimize the impact on your tax situation.
The previous example shows that converting a traditional IRA to a Roth maybe a good idea. Now let’s look at another benefit of the Roth IRA, called a stretch Roth IRA. The term “stretch” applies to both Roth and traditional IRAs and it simply means transferring an IRA at death to your beneficiaries so it can be stretched over their lifetimes. Your beneficiaries (let’s assume children) inherit your traditional IRA or Roth IRA. With a traditional IRA, your children will be required to take distributions each year based on their life expectancy and those distributions will be taxed at their own tax rate. If they inherit your Roth IRA, they will be required to take annual distributions, just like with a traditional IRA, but they will never pay taxes on those distributions for their entire life. Even at the lowest end of the tax range, which we stated earlier is most likely to rise, the lifetime tax effect can have a devastating impact on asset
So what’s so great about a Roth IRA? Tax-free compounding that’s what!
values. Using our previous example, an after-tax annuity distribution (28% federal tax rate) to an heir that totally depletes the $150,000 account would provide an annual payment of $11,300 to the Roth IRA owner for 30 years versus $9,085 to the traditional IRA owner over the same period. That’s more than $2,200 per year for 30 years.
If you believe your taxes are going up and will stay higher throughout your retirement, then converting to a Roth IRA maybe a timely strategy for you. The impact on your financial position and that of your heir(s) can be significant, so don’t miss this incredible opportunity to take advantage of current low tax rates to improve your family’s financial situation.