IRAs and Roth IRAs: What You Need to Know Before You Make This Retirement Account Switch

by Karim Rahemtulla Investment Wisdom Investment Wisdom

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.

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