IRAs and Roth IRAs: What You Need to Know Before You Make This Retirement Account Switch
by Karim Rahemtulla, Options Expert
Monday, January 11, 2010: Issue #1172
Let’s talk retirement – and specifically, Individual Retirement Accounts (IRAs).
Simply put, these are accounts that investors set up to save for retirement. They come in various forms, including the two that I’m going to talk about here – traditional IRAs and Roth IRAs.
On the surface, a Roth IRA seems like the best bet, as it allows for tax-free accumulation of profits on your contributions. A great idea, for sure. But there’s a catch: It’s always been restricted to people who earned less than a certain amount. If you earned more, you were forced to use a traditional IRA, where the gains are taxed.
Until now.
A recent change in the tax laws regarding qualifications for Roth IRAs, versus traditional IRAs, should have many folks jumping for joy….
Until this year, you couldn’t qualify for a Roth IRA unless you fell below specific income requirements. But the government has now decreed that anyone can have a Roth IRA, regardless of their income level. Furthermore, if you have a traditional IRA, you can switch it over to a Roth – with all future gains and distributions being tax-free.
Super. Break out the champagne, right?
Not so fast…
The Roth IRA Trap
While spending your hard-earned money tax-free when you retire sounds like a great idea, there are catches. Several catches. And you need to be well-informed before you even think about making the switch to a Roth IRA.
Here are just a couple of issues:
- Government: The government is angling for a lot of cash with this move. Think about the trillions of dollars sitting in retirement accounts. The lure of collecting taxes early on those trillions makes even the sleepiest bureaucrat wake up.
- Tax Implications: Any money you switch from your regular IRA to a Roth will be taxable. This means you’ll pay tax on these funds at the marginal rate over a couple of years.
However, if you’re at the 25% tax rate and you decide to make the switch, the amount you transfer will increase your marginal rate and may push you into the 35% bracket or higher.
Ask yourself this: What will your estimated tax rate be at retirement? If it’s going to be lower and you’re within a few years of retiring, the Roth switch may not be for you.
In addition, the taxes due must come from somewhere. For example…
The Traditional IRA: Switch to a Roth IRA Now Or Pay Later?
Let’s take a traditional IRA with $500,000 in it.
If you switched to a Roth IRA, you’d owe at least $175,000 in taxes at the 35% tax rate. That would leave your investible capital at $325,000. But the pros tell me that you need to pay that $175,000 out of other funds so your IRA is intact and can earn money tax-free without having to spend years getting your principal back to square one. Hmm, now where can I find an extra $175,000 lying around?
The thinking behind making the Roth tax switch now is simple: Taxes are going up (maybe way up, thanks to our lavish spending habits), so better to cough it up now before you really have to hand over some big bucks later.
In fact, it’s not out of the realm of possibility that marginal tax rates will top 50% for the highest earners within a couple of years – something that would make the Roth switch really expensive.
The upside, however, is that tax history doesn’t usually change because of fiscal responsibility, but because of political will. Over the past 40 years, we’ve seen marginal rates decline from over 70% to the low 30% level.
And while we’re on the upward slope today, who knows where we’ll be in 20 years?
Thinking About Switching to a Roth IRA? Consider This…
Taxes might have declined by the time you take a distribution. So scare tactics aside, let’s look at a couple of solutions…
- Status Quo: The easiest thing to do is let your traditional, tax-exempt IRA continue to grow and just pay the taxes at the marginal rate upon distribution. The money you’d have to find to pay the taxes today (compounded at a reasonable rate going forward) would likely make up for a good chunk of what you’d pay in taxes later anyway. And if your rate is lower in the future, you may actually come out ahead if you’re looking at a period of 10 or 20 years.
- Switch in Stages: If you’re going to switch to a Roth IRA, don’t let the government fool you into thinking that you can pay the taxes over the next two or three years. From what I can tell, it’s a gimmick – it wants the money now.
Instead, consider switching over a longer period of time, transferring just enough each year, so that your tax bite doesn’t vault you into some ungodly high tax bracket. For example, if you have $500,000 to switch, transfer $50,000 a year over 10 years and pay the tax on that amount – it’s a lot more manageable. Check with your accountant that there are no future restrictions on switching your IRA in this way. If not, why do it all at once?
The bottom line: The Roth IRA switch is good news, but it’s nothing to write home about. If it was, I assure you the government wouldn’t be pushing it so hard!
Good investing,
Karim Rahemtulla
P.S. Please note that this column is just to bring the Roth IRA subject to your attention. Make sure you check with your accountant before you do anything.
Any investment contains risk. Please see our disclaimer.
13 Responses to “IRAs and Roth IRAs: What You Need to Know Before You Make This Retirement Account Switch”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
Did I get it right, the entire dollar amount in the traditional IRA must go into the Roth IRA? The new Roth will be equal, dollar wise, to the old traditional IRA. Therefore, the money to pay the taxes on the old IRA must come from other earnings or savings. Wow, that’s tough!
Dave
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Roth conversions are a lot better than the article states. A Roth conversion comes with a money back guarantee! Make the conversion early in the year and then wait until up to October of the following year to recharacterize any portion that you don’t want to pay taxes on. If you get lucky and your portfolio rises 40% then it doesn’t matter so much that you are paying a higher marginal rate because it is on a much smaller basis.
I have also heard of a strategy that involves having several Roth IRA accounts invested in different sectors. That way you can recharacterize just the poor performers. The IRS treats all Traditional IRA accounts as one big IRA but Roth IRA accounts are considered separate entities.
The other major benefit of Roth IRAs is estate planning. Roth IRAs transfer their tax advantages to your heirs. Tranditional IRAs transfer an accelerated tax burden to your heirs.
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Karim,
Thank you for clarifying this issue for me. I’ve been considering this very transaction with my traditional IRA, so your article was timely.
Thanks for looking out for us “regular guys”!
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I’m no tax expert, but my read on the situation is that there’s not a lot of harm in maxing your Roth IRA early in the year and then adjusting it later if need be. You just need to be aware of how to fix it and make sure you do so before your taxes are due.
I found more information here:
http://www.rothirarules.net
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You may want to recheck some of your facts. It is my understanding that if you switch in 2010, you calculate tax based on your 2010 income [including amount swithced], and pay tax in two installments, in 2011 and 2012, not pay based on income tax rate in those two subsequent years. It is a one time spread-out-the-payment benefit – like was done when Roth began, for switch in that first [one] year, allowed to be spread over 4 years beginning the year of switch under that earlier law. BIG DIFFERENCE FROM YOUR COMMENTS.
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Your Roth article was spot ON. Thanks. But for someone just retiring or already retired and wanting to minimize the amount of time spent managing his/her retirment funds in an IRA, which Oxford investments among these 3: Perpetual Income, Ultimate Retirement, Gone Fishin, would be the best choice?
Then, using $100,000 as a base figure, should one put a certain % in each stock or fund or a certain $ amount? Should the purchases be made all at once, or spaced out, say so much each month?
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Our Traditional IRA’s have no guarentee at what tax rate we will have to pay when we need the income for retirement. The Roth IRA is a known -no rate. At some point the US government is going to have to balance the budget. To do this, has there been any hypothetical models on what our taxed rate could be in the retirement years ahead?
Is this good enough reason to switch while the tax rate is considerably lower?
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What about having two account, one traditional and one roth, and contribute one year to the traditional and the next to the roth?
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If you are looking at a higher tax rate for the future, instead of converting to a Roth, take the $175K you would use for taxes and invest in a closed-end portfolio of munis with a 5-6% tax free yield. That will go a long way of offsetting a rollover to the Roth. Also, the Trad IRA, if set up propertly with the beneficiaries, will be spreading the payout of the IRA over the life expectency of the beneficiaries. So, considering the time value of money, where is the benefit.
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CONGRATULATIONS ON YOUR SUCCESSFUL ATTEMPT ON EDUCATING THE PUBLIC ON THE PROS AND CONS OF AN IMPORTANT FINANCIAL ISSUE @ REGULAR IRA’S VS. ROTH IRA’S
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Already a member. Would like to take advantage of infl on Fredonia Reactor. How?
Thank you.
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Stanley,
If you’re already a member, all you need to do is go to http://www.oxfordclub.com and click on Urgent Investor Reports on the white bar going across the top of the screen. The Fredonia Reactor report should be the very first one listed in that section.
Thank you,
Investment U
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Thank you for this clarification, it really helps me straighten out my Roth IRA conversion. Although I might be ineligible for Roth IRA very soon as my adjusted net income will be >100k.
Roth IRA
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