The IRA After Your IRA: The Roth Conversion

"There seems to be a lot of people thinking about post-retirement distribution planning," says Dave Zimmerman, financial advisor with Salomon Smith Barney. "But I would like to see them being more proactive than reactive. Don't wait until you're forced to make a decision. Find out what alternatives you have now."

Indeed, poor post-retirement distribution planning can force retirees to sell off assets, pay outsized tax bills on Ira distributions, or dramatically scale back their standard of living because their post-retirement investments do not provide sufficient reliable income. Working Money introduced common distribution strategies such as annuity payouts and lump-sum distributions in the May 2001 issue with "Cracking Open Your Nest Egg" (available at www.working-money.com). It's also worthwhile to consider what might seem to be better than both worlds: rolling over your IRA into another IRA - the Roth IRA.

THE ROTH REVOLUTION

Many thought that the original individual retirement account (Ira) was an excellent first step in providing tax relief and assistance to working people saving for retirement. However, the growing popularity of individual retirement accounts encouraged people to demand more flexibility and more control over their retirement savings. The Roth IRA, created by the Taxpayer Relief Act of 1997, differs from the traditional Ira in a number of ways. "The Roth IRA is a retirement savings account," explains Zimmerman, "which gives greater flexibility to investors in using their retirement assets to fund additional long-term goals."

A traditional IRA allows workers to invest a portion of their income in a tax-deferred investment account. The amount contributed to a traditional IRA may be deducted from the contributor's income taxes, and the invested money is not taxed until it is withdrawn. Contributions to a Roth IRA , on the other hand, may not be deducted from current income taxes. However, distributions (or withdrawals) from Roth IRAs are tax-free when taken after the age of 59-1/2, assuming the Roth IRA account has been open for at least five years.

While the tax deductibility of contributions to traditional IRAs is nothing to sneeze at, Roth IRAs have some tangible advantages that many investors should consider. For those who have fully funded workplace 401(k)s (which are tax-deferred), Roth IRAs can be an excellent vehicle for further long-term investments. Since contributions are from aftertax dollars, the distribution rules for Roth IRAs are less restrictive than those for traditional IRAs . Roth IRA distributions also are not considered reportable income as far as the IRS is concerned, which help keep post-retirement tax bills low. Another benefit of Roth IRAs is that while traditional IRAs force accountholders to begin taking annual distributions by age 70-1/2 (if they have not done so already), Roth IRAs have no such requirement.

Roth IRAs - once dubbed "The American Dream IRA" by early boosters - do have their downside, however. As Zimmerman points out: "Not everyone is eligible to establish one. Further, the time and growth of assets needed to take advantage of the lack of income tax deduction that may be available through a [traditional] IRA may be detrimental to establishing a Roth IRA. ... Remember, you're contributing to a Roth IRA with aftertax dollars."

Eligibility requirements for Roth IRAs are not especially stringent, but they do exist. Earned income is a necessity, as is an adjusted gross income that is less than $95,000 for a single individual or $150,000 for a joint filer. (Partial contribution plans are available for single taxfilers with adjusted gross incomes between $95,000 and $150,000.) These requirements tend to squeeze out those on the upper end of the tax spectrum, as well as many of those who are married but file taxes separately.

Zimmerman's other point, about the relative merits of Roth IRAs versus traditional IRAs when it comes to income tax deductibility, is worth underscoring. Most people pay less in taxes as retirees than they did as working adults. As such, there is a real benefit with a traditional IRA to taking a deduction against today's larger tax bite, again assuming a lower tax bracket in retirement.

Remember, the name of the game is to invest as much as possible as soon as possible. Tax-deductibility of investments is helpful, and saving money on taxes can be an effective spur to further investment. But assuming you don't need the tax relief today, the Roth IRA over the long term can be much more advantageous for bigger savers. (Also remember that as of this writing, $2,000 is the maximum amount that can be contributed annually to both traditional and Roth IRAs.)

For the taxpayer with more than $2,000 available to contribute toward retirement savings, the Roth IRA offers an incredible upside over a nontax-protected investment account - and it is for these taxpayers that the Roth IRA does become the American dream (see sidebar, "A tale of two IRAs"). Even the most tax-efficient mutual fund cannot compete with the thoroughness of the tax protection provided by a similar mutual fund wrapped in a Roth IRA.

MAKING THE MOVE TO ROTH

What special attractions do Roth IRAs have for those who have already retired? As mentioned, the 70-1/2 mandatory age for the start of distribution of traditional IRAs does not apply to Roth IRAs - meaning seniors springing into their 70s and 80s can continue to take advantage of the special tax status of the Roth IRA, which does not tax distributions. In this manner, seniors can shield their estate from taxes by converting their traditional Ira plan into a Roth IRA. They can also convert an employer-based 401(k) plan into a traditional IRA plan and then convert that IRA plan into a Roth. This would enable heirs to take distributions from the estate with the tax-free protection of the Roth IRA (though these distributions would be subject to the minimum distribution rules of traditional IRAs).

How difficult is it to convert from a traditional IRA to a Roth IRA? Or from a 401(k) plan to a Roth IRA? Again, an employer-based 401(k) plan needs to be converted into an IRA rollover first. But should an employee decide that a Roth IRA better suits his or her long-term investment needs, converting to a Roth is usually a simple process.

"If you have an existing Ira outside of an employer plan, you may simply convert all or some of your assets to a Roth," says Zimmerman, "provided your [adjusted gross income] is $100,000 or less [joint or single]. Also, if you are married, you must file a joint income-tax return in order to convert to a Roth IRA."

The conversion penalty is one of the few obstacles that can deter workers from converting their traditional IRAs to Roth IRAs. This is essentially a requirement to pay off any accumulated taxes on the traditional IRA. In a sense, the accountholder withdraws some or all of the money from the traditional IRA, pays a penalty equal to the amount of deferred taxes on the account, and then reinvests the money in the Roth IRA. And if the conversion penalty can be paid without sacrificing any of the assets in the IRA, then so much the better. Those considering the conversion should do the math before deciding whether the Roth IRA might be a superior solution. For many who are enjoying the tax deductibility of their traditional IRA contributions, though, the idea of interrupting those tax benefits - and paying some extra dollars, to boot - can be loathsome.

"What's the benefit of converting?" Zimmerman asks. "In exchange for incurring the income tax liability of the conversion amount, you are entitled to receive future Roth IRA distributions at age 59-1/2, and after five years, entirely income tax-free. However, the key is time. The longer you wait to do a Roth IRA conversion, the less time you have to recapture the initial income-tax liability paid out to establish the conversion."

Although the Roth IRA provides significant advantages for those able to exploit them, it is important to assess your overall financial goals, current and future income and potential, and any long-term savings plans to see which vehicle is best suited to take you where you want to go. It is also important to see individual retirement accounts - Roth or traditional - as just one part of the retirement and post-retirement planning process.

"Several questions must be addressed for post-retirement planning," concludes Zimmerman. "What sources of income will be available? How much do you anticipate needing to satisfy living expenses? Do you still have outstanding debts or mortgages? Do you plan on traveling? Do you plan on selling your home? It's very important to consider these issues before you are fully retired."

David Penn can be reached at DPenn@Traders.com.

SUGGESTED READING

Faber, Bruce R. [2001]. "The Bill That Didn't Pass," Working Money, Volume 2: April.
_____ [2001]. "How To Save $13.25 Per Mile. Really!" Working Money, Volume 2: January/February.
Penn, David [2001]. "Cracking Open Your Nest Egg," Working Money, Volume 2: May.

Copyright © 2001 Technical Analysis, Inc. All rights reserved.