So you didn’t convert to a Roth IRA last year, and now you’re kicking yourself?
Stop crying over spilled milk. If converting really made sense last year, it probably still makes sense today.
Investors who didn’t convert their traditional individual retirement accounts to Roth IRAs in 1998 did miss out on a one-time tax advantage that expired Jan. 1. People who converted before then got to spread out the income tax on the converted assets over four years, starting this year, rather than having to pay the entire tax in one year.
The special tax break was no small advantage. For investors transferring sizable funds, paying the tax on the converted assets all at once can mean having to hand the IRS tens of thousands of dollars by April 15 of the following year. Say you convert $50,000 this year and you’re in the 33 percent combined federal and state tax bracket, you’ll owe $16,500 on the conversion alone by the 2000 filing deadline.
To avoid that kind of tax hit, investors flooded brokerage firms, banks and mutual funds in the final weeks of 1998, wanting to convert by year’s end.
But there are still ways to ease the tax burden for those who convert this year, says Thomas Ochsenschlager, a partner at Grant Thornton in Washington. To get a similar effect, you can convert a quarter of your IRA this year, a quarter next year and so on, he says.
Moreover, says Jim McCarthy, vice president of retirement services for Merrill Lynch: “The four-year spread wasn’t the economic argument for converting to a Roth in the first place.”
In a traditional IRA, contributions may be tax deductible and taxes are owed on withdrawals. In a Roth, contributions aren’t tax deductible and they grow tax free. And unlike a traditional IRA, from which investors must start taking withdrawals after they reach age 70 1/2, a Roth has no distribution requirements. This means those who don’t need their IRA money during their lifetime can pass their account intact to heirs.
Even better, heirs don’t have to pay income taxes on assets inherited in a Roth, as they do with a traditional IRA. (Both accounts are subject to estate taxes.)
These features add up to a compelling advantage for many investors, though it’s not a sure thing, says Michael Stalker, a chartered financial analyst in Eugene, Ore.
“It’s been put out there as a no-brainer, like, `Why wouldn’t you do this?’ but there are actually a number of situations in which you shouldn’t,” Stalker says.
For one thing, you must have the cash outside your IRA to pay your tax bill, experts say. If you use funds from your IRA to cover taxes, you’ll not only owe a 10 percent penalty for early withdrawal (if you’re under age 59 1/2), but you’re also setting back your retirement savings too far to make a Roth IRA worthwhile.
To be eligible to convert, income for singles and couples cannot exceed $100,000.
Converted assets can be withdrawn penalty-free at any age, as long as the account has been held for at least five years. If they are withdrawn before five years, you’ll owe a 10 percent penalty.
Contributions (totaling no more than $2,000 a year) can be taken out tax-free or penalty-free at any time.
Earnings can be taken out tax- and penalty-free only after age 59 1/2 and as long as the account has been held for at least five years.
Still, figuring out if a Roth conversion makes sense can be confusing, particularly considering some misleading generalizations that have emerged in the past year, some experts say.
The biggest myth about the Roth is that you shouldn’t convert if you’re in retirement or if your tax rate is going to decline later, says Ochsenschlager.
True, a conversion is “more of a gamble for some than others,” says John Ziegelbauer, senior tax manager at Grant Thornton. “But it’s case specific.”
A number of factors come into play, such as your tax rate, expected tax rate in retirement, how many years you will invest and the expected rate of return, and how you would invest money that would have been used to pay taxes on converted assets if you don’t convert.
A conversion is going to look less attractive if your tax rate in retirement is likely to decline, because you’ll pay a higher rate now to convert than you’d pay on withdrawals from your regular IRA later.
But the transaction may make sense; you simply may need a longer investment time horizon.
Take an investor in the 36 percent federal tax bracket paying state taxes at a 7 percent rate–a combined 40.48 percent when the federal deduction for state taxes is taken into account–who converts $10,000 to a Roth IRA from a traditional deductible IRA. Assume his combined tax rate falls to 33.04 percent in retirement. If he earned an average annual return of 10 percent, an analysis by Grant Thornton shows he would need to hold his Roth investments 12 to 13 years before he benefited from converting.
If he earned an average annual return of 6 percent, it would take 20 years for him to come out better than if he had left the money in a traditional IRA. Someone in a lower tax bracket would need less time to come out ahead.
Grant Thornton’s analysis assumes that if the investor didn’t convert, the money he would have used for taxes in a conversion earns the same return–10 percent or 6 percent–and is subject to long-term capital-gains rates.
The benefits of converting are also more uncertain for older investors, because they may have a shorter period to invest before taking withdrawals. “But people have to run the numbers,” says Ziegelbauer.
