posted 04/30/10 | Wealth Management
Drew McLaughlin, Vice President & Client Advisor, Enterprise Trust
Why is the Roth IRA getting so much attention right now? Does it make sense for me to have a Roth IRA? These are some of the questions on the minds of higher income individuals.
The main reason the Roth IRA is in the spotlight is the fact that converting to a Roth for wealthier families was not an option until 2010. Additionally, anyone that converts to a Roth in 2010 has the ability to pay the tax over a 2 year period. The IRS did not lift all restrictions on Roth creation or conversion, income and contribution limitations remain unchanged. We will walk through the history of the Roth, who is eligible and some points to consider.
The Roth IRA was born on January 1, 1998 as a result of the Taxpayer Relief Act of 1997. It was named after a senator. The Roth IRA is almost a mirror image of a traditional IRA. A tax payer contributes after tax dollars to a Roth and takes distributions from the Roth tax free. Until 2010, the IRS did not allow a conversion to a Roth IRA unless the tax payer had less than $100,000 of (MAGI) modified adjusted gross income. Now the IRS has lifted that restriction indefinitely.
A large majority of the IRA owner population has the ability to convert to a Roth. One may convert if they, own a traditional IRA, a SEP IRA, a SIMPLE IRA, a 401(k), a 403(b) or a 457 plan. Certain owners of spousal inherited retirement plans such as IRA’s or employer sponsored plans (401(k)’s etc.) may convert. A non-spousal beneficiary of an employer sponsored retirement plan may not convert.
One should consider the time horizon, who will spend the money, current and future income tax rates, and how they will pay the tax. First, the individual should analyze the time frame of the assets in the IRA. This could be the IRA owner’s retirement and life expectancy or their beneficiary’s retirement and life expectancy etc. The point is to consider how long the asset base will be intact before the funds will be distributed and spent. Once the funds are disbursed, who will spend them? If neither the owner nor the spouse intends to use the funds, they are likely going to be passed to a successor generation. Determining who spends the money helps determine the time frame as well. In general, the longer the time frame, the more successful a conversion to a Roth IRA could be.
If we had a crystal ball, this conversion decision would be easy. Because we don’t, the individual has to assume their future effective tax rates. This is the largest assumption for most families. The current state of our macro economy complicates this process. In general, if your effective tax rate will be higher during the period in which the funds will be disbursed from the IRA, the more successful a conversion to a Roth IRA could be.
If the time frame is relatively long and the owner assumes higher tax rates in the future the conversion tax is next to consider. The owner has the choice to pay the tax from the IRA assets or to pay the tax from another source. In general, the probability of a successful conversion is greater when paying the taxes from another source. This allows the IRA core asset base to grow and take advantage of the power of compounding. The IRS is granting the IRA owner the ability
to pay the conversion tax over two years if the conversion is completed in 2010. They do not have to recognize the income and tax until 2011 and 2012. This tax deferral option is a one-time election that may only be used in 2010.
The planning community has created several techniques and strategies to optimize the potential conversion outcome. There are intricate asset allocation conversion strategies, timing strategies and many others your financial advisor and CPA can discuss.
There are other factors to consider. The traditional IRA has required minimum distributions starting at age 701/2 but Roth IRA do not. The traditional IRA cannot receive new contributions after age 701/2 but Roth IRA can. Contributions to the traditional IRA offer income tax deductibility but the Roth IRA does not.
Individuals considering a conversion should consider the factors discussed here and consult with their tax, financial and legal professionals to determine whether or not a conversion is right for them.