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Why tax pros love Roth IRAs

Why tax pros love Roth IRAs

Many taxpayers are delaying their year-end decisions until they see what Washington does with a host of expiring tax measures, including those affecting dividends and capital gains.

Yet one of the biggest year-end tax moves is relatively removed from the headlines: whether or not to convert a traditional Individual Retirement Account (IRA) to a Roth IRA.

The Roth IRA is partly a play on income-tax rates – you make contributions to a Roth with after-tax money and then don't owe income tax again. If you expect your personal tax rate to be higher when the money comes out than it was when it went in, it's a better deal than a traditional IRA, which allows you to defer the tax hit until you make withdrawals in retirement.

Even though tax gurus love Roths, such accounts made up just 6 percent of the $4.9 trillion in IRA assets at the end of last year, according to the Investment Company Institute. A lot of people may want to consider converting at least part of their IRAs into Roths.

That is because you will not pay taxes on the earnings within your Roth account as long as you wait until you're over age 59-1/2, and the account is at least five years old, before you start making withdrawals of those earnings.

State tax treatment of IRAs typically follows federal law, so the effect of IRA decisions can be magnified in states with high income tax rates.

Younger people can do much better with a Roth IRA because, earnings may outstrip initial contributions as they build up year after year. The simple rule here is, the longer you can leave money in a Roth, the better.

The biggest benefits go to those who use Roths for estate planning and do not actually need to tap their accounts in retirement. Roth IRAs are not subject to rules that force traditional IRA-holders to begin drawing down assets at the age of 70-1/2. Account holders who never use the money and bequeath it to their children or grandchildren will be transferring those tax-free breaks to the younger generations.

This is why financial planners and tax advisers often recommend that wealthy older people who expect to leave an inheritance – even those already in retirement – use a Roth IRA as a simple, tax-efficient way of passing money to future generations. However, Roth IRA balances are included in tallying estates for estate tax purposes.

"We did quite a bit of modeling on Roth conversions, and what we found is that the conversion is beneficial, but in many cases the break-even period is about 20 years," says Richard Baum, a tax partner at Anchin, Block & Anchin, in New York.

"If a client wanted to do the conversion for the benefit of a grandchild, that would make sense," Baum said. "But you do need a long period of time to recoup the tax costs."

A Roth IRA conversion calculator, such as this one from fund giant Vanguard, can help you make the decision about whether to convert. You may want to ask a tax adviser for a more personalized analysis.

For some people, doing a Roth conversion will move them into a higher tax bracket or into the alternative minimum tax – an income tax enacted to make sure the rich pay some minimum amount of tax that is increasingly hitting the middle class.

How much tax you will owe on your 2012 federal tax returns depends on what type of IRAs you hold. Over the years, some people have made after-tax contributions into traditional IRAs, so it is possible to have a fully tax-deferred IRA or one that is only partially tax-deferred.

If you own only IRAs that have been funded with non-deductible contributions, then you will owe tax on the earnings only, since you already paid tax on the original amount when you made the contributions. But if you have only IRAs with deductible contributions, you will owe tax on the full amount you convert, since you contributed on a pre-tax basis.

If you contributed both ways — as many people have — then you will need to figure out your tax hit based on the pro-rata share of each, a rule that prohibits you from cherry-picking among your accounts. The upshot is that your tax bill could range from relatively minor to around one-third of the value of the assets you're converting.

The psychological part of paying taxes early has deterred many people from doing a conversion. If you need to take the money out of your Roth or a tax-deferred account to pay the tax bill on the conversion, do not do the conversion, experts say. Any benefits from the Roth would be outweighed by pulling the cash out, especially if you wind up owing penalties for taking money from a retirement account before the age of 59-1/2.

And what if you pay the tax up front, and then the market goes down, shrinking the assets you converted? While there's little you can do about the investment decision, there is an out for tax purposes: Simply undo the conversion in a process that the Internal Revenue Service dubs recharacterization. So, after going through all of those calculations, you may find yourself with a do-over.

© Copyright 2012 Thomson Reuters.

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