Traditional IRAs vs. Roth IRAs
by Marc Courtenay, Retirement Panel Chairman
I'm writing you this report to discuss my recent conversion.
No, I didn't have a religious experience. Rather, I just converted almost half of my traditional IRA (Individual Retirement Account) into a Roth IRA.
Why'd I do it? It all boils down to controlling (and trying to limit) my taxes.
The Taxman Cometh
No matter when I withdraw funds from my traditional IRA, I will be taxed at the ordinary income rate.
Right now, I have a pretty good idea of what my taxable income will be this year. I also know what the prevailing federal and state income tax rates are. Thus, I can easily calculate how much taxes I'll have to pay.
In the future, I can't be so sure.
Not only is the amount of my taxable income unknown, but so are the tax rates. And given that government debt is already well above one trillion dollars (and regrettably growing a few billion more every day), I think we can all agree that tax reform and tax increases lie ahead.
On top of that, if the investments within my account perform as well as I have planned, my account balance (i.e. - the amount I will be taxed on) will be much greater.
So to put it simply, the decision to convert came down to paying a smaller and quantifiable amount of taxes now... or waiting and paying presumably higher taxes down the road.
I chose the former, especially since new rules that just took affect this year make a Roth IRA conversion more appealing than ever before. I think you'll agree...
Traditional IRAs vs. Roth IRAs
To truly appreciate the benefits of a Roth IRA and the new rules, it's important to first understand the key differences.
The biggest difference between Roth IRAs and traditional IRAs is this: You put after-tax money into Roth IRAs. And since you've already paid taxes on that money, your future withdrawals can be taken tax-free.
More favorably still, any profits you earn on the money can be withdrawn tax-free.
This favorable tax treatment extends to conversion amounts - money moved over from a traditional IRA - as long as the distributions are taken five years after the conversion or the owner is over the age of 59-and-a-half.
(For full details on the requirements that must be met for a distribution to be tax- and penalty free from a Roth IRA, I encourage you to check out pages 64 and 65 in IRS Publication 590.)
So what's the big deal about tax-free withdrawals from a Roth IRA?
The most obvious answer is that if the government raises taxes in the future (which it's most likely to do), it won't affect you. You can invest your Roth IRA so it grows abundantly without worrying about paying any taxes on that growth.
Also, if you decide to pass it along to your children or grandchildren, you can do it tax-free. And the assets will resume their tax-free growth, too - a unique estate-planning advantage.
What's more, you don't have to make any mandatory retirement distribution, like a traditional IRA. This could prevent you from being bumped up to a higher tax bracket in future years.
Three Points to Consider Before Converting to a Roth IRA
I asked the Director of Retirement and Estate Planning and also a member of The Oxford Club's Retirement Panel, for some keys to determine if a Roth IRA conversion may be right for you. Here are the three considerations that he shared with me:
1. Taxes. If you think your tax bracket will be the same or higher in retirement than it is today, consider a Roth conversion. If your taxable income is lower this year than in a typical year, or if you have accounts that have lost value, you may also want to consider a conversion because you're likely to pay less in taxes.
2. Time and Value. If you have five years or more before you plan to begin withdrawing funds, you may benefit from a Roth conversion. Generally speaking, the more time you have before you need the money, the more sensible a conversion is. Also, if you expect your IRA account to grow substantially over the years ahead, this would increase the potential long-term benefits of converting to a Roth IRA.
3. Cost and the "Deferral Option." If you think you're a good candidate for a Roth IRA conversion, stop and evaluate whether you have enough non-IRA cash on hand to pay the taxes associated with the conversion.