To Roth or Not To Roth in 2010?
2010 is supposed to be the Year of the Roth IRA, with many people (often at the urging of their financial advisors) anticipating and planning for the opportunity to convert their traditional IRAs into Roth IRAs.
So what's the big deal and could this really be a generous freebie from Uncle Sam that you should take advantage of?
Well, unfortunately the answer is "it depends".
I'd like to provide you with a few key factors to consider in deciding whether the Roth IRA conversion is right for you in 2010.
But first things first, let me start with clarifying a few basic definitions.
Traditional IRAs are retirement savings vehicles with two key characteristics. First, contributions into traditional IRAs are fully tax-deductible regardless of your income, unless you have access to an employer-sponsored plan such as a 401K, in which case you may have a reduced deduction or no deduction at all depending on your income (for more info see the IRS site). For most people who are not self-employed, your traditional IRA are likely the result of having "rolled over" the balances of your 401K plans from prior employers so you are probably not that concerned about new contributions. The second characteristic is the fact that the distributions or money you take out upon retirement are taxed as ordinary income. Said more simply - for a traditional IRA, you don't generally pay tax when the money goes in, but you'll pay tax when the money comes out.
In contrast, a Roth IRA is the other way around. Your contributions are not tax-deductible but your distributions are tax free as long as you are 59 1/2 and have had the Roth for 5 years, and you are not required to withdraw any money at 70 1/2 like traditional IRAs. So for many folks with long time horizons to retirement and potentially more sources of income at retirement, Roth IRAs can be a tax advantage.
So what's with all the buzz around this topic in 2010? Well, as of 2010, a change in the tax law removes the limitations for converting traditional IRAs into Roth IRAs which up until now was limited to individuals/married couples with Modified Adjusted Gross Income less than $100,000 and just for 2010, any tax liability from the conversion can either be fully paid in 2010 or split 50/50 between 2011 and 2012. And on a related note, this rule change does not mean that anyone can fund a new Roth IRA, which still has limitations and phase-outs depending on income (again check with IRS for more details on this).
For many people who previously were not qualified for this due to their income, this could be an interesting opportunity to reduce future tax liability. However, there is not a one-size-fits-all answer for everyone and each individual should consider the following factors in making this decision:
- Your current and expected future income tax rates. When you convert your IRA into a Roth, you will have to pay taxes on the full value of the IRA as ordinary income and depending on your situation may increase your AGI and the resulting tax rate in the conversion year. So if you are in a high tax bracket now but expect to be in a lower tax bracket upon retirement, it would not make sense to convert. Having run the numbers for my own portfolio, let me illustrate using a simplified example.
If you have $10K and convert now, you will have a new principle of $6K if you are at a 40% tax bracket, assuming you pay taxes out of the IRA account, After 25 years averaging a 5% return, you would have $20.3K tax free.
However, if you left it as a traditional IRA earning the same 5% return over 25 years, you would have $33.9K. Assuming a full withdrawal at that point with a lower 25% tax rate, you would have $25.4K (note: if your post retirement tax rate remains the same, there would be no difference and you would have the same $20.3K).
- Your time horizon for investing and expected returns. There's a big difference between an individual in their 30s and a soon-to-be retiree. If you are near retirement, you won't have as many years to make up the tax hit from tax free investment gains, so a conversion likely would not make sense for you. And closely related to this is what you expect your annual returns to be going forward. Given the outlook of the market these days, I would advise against any overly aggressive assumptions on potential returns which would extend the time frame required to make up for the tax hit.
- How you plan to fund the tax liability. If you are paying taxes out of a separate account other than the actual IRA you are converting over, then you can be more tax efficient by maximizing the IRA principle for the investment returns and tax free distributions in the future.
There are certainly lots more nuances to this and there may be some differences from state to state as well so I would advise you to either get more familiarized with the information related to your specific situation and/or get some help. Most importantly, I would suggest that you run the numbers before making your final decision!
Thoughts on Retirement...
Retirement is not a date or a number.
It's a state of preparedness.
I know many people of different ages and economic attainment who are either retired or thinking about retirement. And consistently the theme that I come across is that irregardless of whether you are a young mega-millionaire or an everyday worker nearing conventional retirement age, the key driver of a successful transition into retirement is simply being prepared.
While a solid financial plan can certainly be a key part of that preparation, most people focus solely on this dimension and don't think about a game plan for what they want to do once they walk away from their careers. As a recently retired friend of mine puts it, it's about relevance - which for many is inexorably tied up in the work that they've chosen to do for most of their lives. So having a plan for how to remain relevant in different ways can make the difference between success and failure. Also important is the social dimension which many retirees miss when they leave the work force. Unless you prefer to golf alone or dine alone or have a spouse who would welcome your sudden abundance of free time, you'll need a plan to acquire the social interactions that you will need once you can no longer rely on your fellow colleagues.