TAX FREE INCOME FOR LIFE SOUNDS GREAT, BUT ...
Roth IRA’s differ from their Traditional
cousins in that all qualified withdrawals from a Roth are free of income
taxes. On the surface, the decision to
convert your retirement savings into a vehicle that could produce tax free
income sounds great.
You Need a Plan
About the Author
In reality the Roth conversion decision is complex and
there aren’t simple rules of thumb that you can use very well. Each person’s financial picture is
different. Further complicating the
decision is that assumptions need to be made about investment returns and
future income tax rates. Making the
correct decision could save tens or even hundreds of thousands in taxes over
There are simple calculators available that offer a quick
answer to the question but these require you to input your current income tax
rate as well as the rate you’ll pay during your retirement years. If you’ve ever tried to do your own taxes you
know that the tax system is complicated.
Predicting how your retirement income will be taxed and at what rates is
even more difficult.
If you’ve done any tax planning you know that the first
rule is generally to try to defer taxes into the future. By converting your Roth into an IRA the
amount converted is subject to income taxes sooner rather than later, probably
much sooner. In order for a conversion to
make sense you’ll generally need to assume that your tax rate will be lower
today than in the future when you would draw the funds from the Traditional IRA
Income tax rates are the focus of most discussions of
Roth conversions but estate tax rates could be another important factor. At this writing in 2011 the estate tax
rates will differ dramatically over the next couple years. If you have a $3 million dollar estate and
die in 2011 or 2012 there is no federal estate tax because the exemption amount is $5
million. Unless Congress changes the law, in 2013 the estate tax exemption drops to
just $1 million so a $3 million estate could face taxes of $1.1 million at the
55% rate in the future.
The estate tax comes into play with the Roth conversion
because the conversion would result in paying more income taxes and thus reducing
the size of a taxable estate. Americans
that expect to end their lives as millionaires will want to keep a close eye on
the estate tax exemption and factor this into their Roth conversion decision.
Another factor often overlooked in the Roth conversion
discussion is the ability for your heirs to preserve the tax deferral of your
IRA by establishing a Beneficiary IRA.
Your heir can decide how much of the IRA they want to spend and they
only need to withdraw the Required Minimum Distribution based on their life
expectancy. A 40 year old IRA
beneficiary would only be required to withdraw and pay income taxes on about
2.5% of the account value each year. The
remaining 97.5% can continue to grow tax deferred. This may allow your Traditional IRA to
continue to enjoy tax deferral for decades after your death.
The biggest factor in the Roth conversion decision is
your income tax rate on the conversion versus the tax rate you’ll be subject to
during your retirement years when you’ll draw out the Traditional IRA
funds. Many people feel that tax rates
will need to increase in the future in order to service the country’s growing
debt levels and they may well be right.
Making the assumption that you’ll be in a higher income tax bracket,
though, could be a costly mistake. Most
retired Americans drop into a lower tax bracket during retirement today and
there’s little reason to think that the graduated rate structure will change in
You Need a Plan
The best way to assess whether a Roth conversion could
save you taxes is to look at your retirement income plan. What sources of income will you have and how
will those be taxed? Today stock dividends,
interest income, Social Security, and municipal bonds are all taxed at
different rates. By assessing your
likely retirement income level and the sources you can better estimate your
future tax bracket.
The calculations should also address state income taxes,
potential estate taxes, and the likelihood of your beneficiaries utilizing a
Even if it doesn’t make sense to convert your Traditional
IRA to a Roth you may want to consider directing some of your retirement
savings to a Roth IRA or Roth 401(k).
At Vintage Financial Services we’ve developed an analysis
that addresses all of the above factors to help you make a more educated
decision. We’ve also allowed for different income tax
and estate tax rates in the future. We
can assume income tax rates remain as they are today, revert to the structure
under the Clinton administration or climb even higher for the Obama defined
“rich” that earn more than $250,000.
The Roth conversion decision is one you’ll make
actively--or passively by ignoring it.
One route or the other could mean a big difference in your tax bills
over the years. We can help you make a
smart decision and also address your overall retirement planning strategy. Contact us today to learn if you are headed
in the right direction.
About the Author
Frank Moore, MS, CFP has counseled clients on retirement
strategies since 1983 and has worked with Roth IRAs since they became available
in the 1990’s. His firm, Vintage
Financial Services, manages retirement assets in many different types of