To Roth or Not To Roth – That is the Question
So 2010 is upon us and there is a lot of controversy regarding whether folks should convert their Traditional IRAs to a Roth IRA. Some of you might be wondering what exactly is a Roth IRA, well, here’s the basics:
A Roth is funded with after-tax contributions; the money grows tax-deferred; and withdrawals are TAX FREE!
In other words, you use money you’ve already paid taxes on to fund the Roth, and provided you meet certain qualifications you never have to pay taxes on that money again!
What is a Roth IRA Conversion?
A Roth IRA conversion then is taking money from a Traditional IRA, pulling it out and putting it into a Roth IRA where it will grow tax free.
Sounds good right?
Well, the problem is that whenever you do this you have to pay taxes on the amount you withdraw from your Traditional IRA.
So, let’s say you are converting $5,000 from your Traditional IRA — you would have to tack on 5G’s to your income for the year and pay tax at whatever rate you are at. It’s as if you earned an additional $5,000 of income for the year.
As many of you already know, one big change for 2010 is that anyone can convert to a Roth regardless of income level. Previously, if you made over $100,000 you could not convert to a Roth.
If you convert your IRA to a Roth in 2010, you now have a choice to pay all of your taxes in 2010 or average the taxes owed on the conversion over two years (i.e. pay in 2011 and 2012). Uncle Sam is giving you a choice on when you pay your taxes.
Don’t forget though that 2010 is the last year for the current low income tax rates. The current law plans for higher tax rates in 2011 — so, if you chose to average your tax payments over the two year period in 2011 and 2012, you might get hit with higher tax rates. That Uncle Sam – he’s always got an angle doesn’t he?
Should You Roth It?
Back to the question at hand. Should you convert to a Roth IRA or not?
Usually the answer to such questions is “it depends”. This might be a great year to convert your money to a Roth and potentially pay lower taxes than you would normally if you are in a lower bracket due to retirement or a layoff and you’ve got some cash on hand to cover your taxes!
This is important because if you are under 59 1/2 and use your IRA to pay the taxes on the conversion you’ll get whacked with a 10% penatly on top of the taxes!
Also, although the markets have rebounded significantly, account balances are still off their 2007 highs. If you convert when accounts are lower, it will result in less overall tax paid plust all the earnings and growth will be tax free!
Factors to Consider
- Do you have money to cover your tax liability? Having cash on hand to cover your taxes will help soften the blow.
- Will the money you convert push you into a higher tax bracket? If so, you probably don’t want to do it.
- Do you have non-deductible contributions in your IRA? No taxes are due on the non-deductible portion. *There are some additional factors to consider here that go beyond the scope of this post.
- Are you planning on applying for financial aid for yourself, your spouse or your child? Better think twice about the conversion – conversion income counts on your application.
Ultimately, whether you convert your Traditional IRA to a Roth will not determine your retirement success, there certainly are other factors to consider to help you make a great run at retirement.
Consider these factors and your overall situation to determine whether the Roth IRA conversion makes sense for you in 2010.
What do you think? Will you be converting to a Roth this year?
{ 10 comments… read them below or add one }
Thanks for the article Jason! Did you recently ad a picture? I used to be a proponent doing a ROTH IRA until I read this article: http://www.financialsamurai.com/2010/01/11/be-a-sloth-and-dont-roth/
Now, I’m happily keeping as much of my savings money as possible. I’ll let the government take other people’s money to support their spending splurge. But not me. I can’t condone giving the government more money to spend on waste.
Jennifer, thanks for the comment. I love differing opinions, however, I am not a big fan of black and white answers. These decisions are best done on a case-by-case basis.
As I addressed in the post, the answer to whether you should Roth it or not is “it depends”. I also addressed Uncle Sam’s craftiness regarding the higher tax rates in ’11 & ’12, which has oftentimes gone overlooked in many posts I’ve read.
Most opponents to the Roth conversion take nothing into account for the fact that Roth’s are tax free for life and are passed tax free to your heirs when you die.
Passing your Traditional IRA to your beneficiaries could generate upwards of 40%-50% tax revenue for Uncle. Food for thought.
Does it mean you should convert? It depends.
Jason, great point about the ’11,’12 tax rates. I agree with your “it depends” argument (b/c everyone is different), and I’d also add that it doesn’t make sense unless you can pay the taxes with cash outside your IRA.
The way our government spends money I will gladly pay the taxes now. You also noted one of the coolest features of the Roth which is inheritance! What a blessing THAT would be for you kids!
Jennifer:
I hate to tell you but whether you convert or not does not stop Uncle Sam from taking his piece and spending it (or blowing it) however he chooses. The government is going to collect the IOU that they attached to all pre-tax retirement dollars. Death and taxes right? Oh yeah, like Jason said it could be 40-50% or more if you die with pre-tax retirement dollars.
Yes, I love the Roth and actually like it over 401k right now. It makes things easier to keep track of and keeps things less stressful.
What do you think? Will you be converting to a Roth this year?
I like to convert when the markets are down and my income is down. Last March I converted and my money has since doubled. Bad for Uncle Sam good for me.
DP- good to covert when your income is down, converting when the market is down is a bit of a fallacy.
Follow me, please. 25% tax bracket for easy math. $20K in IRA (down from $40K FWIW) You convert, at a cost of $5K. Market doubles back. You have $40K in the Roth and pat yourself on the back. If you didn’t convert, you’d have $40K in a regular IRA, and the $5K you used for taxes would have doubled as well t0 $10K. (I am not ignoring that the $5K gain carries a potential tax liability, in the big picture the $750 in cap gain is pretty small compared to the tax you’d pay at 25%).
So long as you convert while in the lower bracket, you’re doing the right thing.
Joe I do not disagree with you at all. What I am saying is if you are going to convert do it when the market is down you will pay less taxes on five grand than ten grand in any tax bracket. To make a more recent point if you converted at the end of January as opposed to the first of January you would have paid tax on 5 percent less money. I understand no one is going to tell you when the market is at the bottom and if they did I for one would not believe them. That said if you have dropped to the 10 percent bracket for one year due to a lay off it makes sense to convert that year regardless of where the market may be.
Joe – I like where you are coming from. A lot of folks don’t point that opportunity cost out.
However, you are making a big assumption that the money you’d use for taxes is in a similar investment with 100% return as well, which is probably not very likely. If your $5,000 comes from cash, then your opportunity cost on that $5,000 is a measley 1% in this environment.
Also, the $20k you made back in your Traditional IRA will be taxed at ordinary income levels as well.
What about investing in Roth 401(k) in 2010?