This is a perplexing question many investors are asking themselves in the wake of recent tax law changes. Should an individual take a distribution from an existing IRA and roll it over (i.e., convert it) to a Roth IRA? A good question, but not so fast. The answer is much more complicated!
Beginning this year and thereafter, the long standing $100,000 Adjusted Gross Income limit has been eliminated, opening up the possibility of conversion to many more taxpayers. To sweeten the pot, the IRS is allowing (for conversions in 2010 only!) an election which can be made to defer the tax liability from 2010 and spread it out equally in the 2011 and 2012 tax year. If this election is not made, the taxes will be recognized in the year of the conversion ? 2010.
Before taking the plunge, there are a number of interesting factors which need to be considered. Conventional wisdom suggests that most taxpayers expect to be in a lower tax bracket when they retire. Sound advice based on this assumption would suggest deferring taxes to the greatest extent while working and distribute the dollars as taxable income during retirement at a lower bracket.
Not so fast! Consider the following questions’What is the likelihood of higher marginal tax rates in the future? Will current deductions for dependents, business expenses and mortgage interest still be available to offset retirement income? What’s the likelihood of working into retirement? Is the objective of the IRA to accumulate assets for heirs?
There are also several other considerations beyond the scope of future tax rates. The age of the individual electing to convert from a traditional IRA to a Roth is important because the advantage of tax-free distributions from the Roth is leveraged by the length to time the dollars can grow. This advantage generally decreases as age increases.
Another factor of note is that, unlike traditional IRAs, Roth IRAs are not subject to the Required Minimum Distribution rules. This can be an important benefit should the retiree not need a planned distribution from the IRA to maintain standard of living.
In summary, there are many variables in the traditional vs. Roth equation that should be evaluated on a situational basis. There is no simple formula that spells out a clear decision. An individual’s IRA strategy should be integrated with their overall financial and estate plan to achieve optimal results. For many people, the guidance of a professional financial advisor will be a critical aspect in making the decision that is right for them.
James B. Kruzan, CFP? is a Registered Principal and Branch Manager for Raymond James Financial Services, Inc., Fenton and Clarkston.