The mechanics of IRAs and other retirement plans such as 401(k)s are generally well-understood. When you contribute to your Traditional IRA you receive a deduction and it grows tax-deferred until it is withdrawn, at which time it is reported as ordinary income. The same is true for 401(K) plans: the amount contributed is not included in income, and it grows tax-deferred until withdrawn. Amounts withdrawn are reported as ordinary income. Both IRAs and 401(K) plans have required minimum distributions (RMDs) beginning at age 70 1/2.
On the other hand, contributions to a Roth IRA do not get an up-front tax deduction, but grow tax-free (as opposed to tax-deferred), and both contributions and earnings are tax-free when withdrawn (as long as the account has been open for 5 years). Withdrawals before age 59 ½ are subject to a 10% penalty for early withdrawal. Roth IRAs have no RMD.
Contributions to both regular IRAs and Roth IRAs are limited to $5,500 plus and additional $1,000 for those over 50 years of age. There are also further limits for high income earners so many high earners are unable to make annual Roth contributions at all. Here is the hidden gem: you can convert existing retirement plans to a Roth IRA without any limits, allowing you to build up the balance of the Roth much faster than by just making an annual contributions under the limits above. There is not an income limitation, so even high earners can do conversions. Yes, you do have to report the amount converted as ordinary income, but you can change your mind at any time before filing your return. So if you do a Roth conversion in January of 2015 you have until the due date of the return, which, with extensions could be as late as October 2016, to change your mind and re-characterize it back to a tax-sheltered plan.
Another benefit is that Roth IRAs do not have an RMD during the lifetime of the owner. At the owner’s death, the beneficiary of the Roth must start taking RMDs over his or her lifetime. For example, a 65 year old lady making a conversion today might live another 25 years. If she named her granddaughter as the beneficiary who was in her early 30’s at her death, the granddaughter will have to begin making withdrawals over the next 50 years. Assuming the granddaughter only withdraws the minimum, it will be 75 years of tax-free growth before the last of the Roth monies is fully distributed. To me this tax provision is just too good to last for many years and at some point I expect Congress to put limits on conversions.
One of my clients who is on a salary has already decided to make the maximum contribution to her 401(K) of $23,000 (if she were under 50 years old the maximum would be $17,500) and will make a corresponding Roth conversion of the same amount. This way she will be paying no more tax than she would have had she not had the 401(K) plan contribution. In doing so, she will be setting aside funds for retirement and will benefit from tax-free growth until withdrawal. Had she merely taken the funds and put them in a savings or brokerage account, her current tax would be the same, but any future growth would be taxable.
Additionally, in our recent environment of strong portfolio returns, investment gains have the potential to mitigate the tax liability associated with the conversion. An individual with a 40% tax rate converting $10,000 of pre-tax retirement contributions into a Roth IRA would have a $4,000 tax bill, but if the Roth assets appreciate by 20% then the tax payment would feel less painful. If the taxpayer is over 59 ½, part of the Roth conversion can actually be used to pay the tax (without an early withdrawal penalty). Note that if portfolio returns are not satisfactory, the converted amount can be easily reconverted back to its original type without cost or penalty.
Please give us a call to discuss this topic: (808) 526-1990. We can explain how tax rates, investment returns and other factors could play into deciding whether a Roth conversion is appropriate for you. While a conversion will not be appropriate for everyone, it is certainly worth considering.