Should You Convert to a Roth IRA?

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

With a Roth IRA, contributions are not deductible, but—beginning at age 59 ½--distributions can be taken income tax free. Also, there are no required minimum distributions (RMD's) after retirement. A Roth IRA thus contrasts with a traditional IRA. In the traditional IRA, certain contributions are eligible for tax deduction, but those pre-tax monies and any gains upon them will be taxed as ordinary income upon ultimate distribution. Moreover, in a traditional IRA, RMD's begin at age 70 1/2, and there are stiff penalties for missing an RMD.

The problem with the Roth IRA for many people, though, has been its income limits and (like traditional IRA's) very restricted annual contribution amounts. For this reason, most existing Roth IRA's are dinky.

Starting in tax year 2010, there will no longer be income limits on conversion from traditional IRA's or other qualified plans (such as 401-K's) to Roth IRA's. Certain companies are now also offering Designated Roth Accounts (DRAC's) as a 401-K or 403(b) option; a business proprietor working alone can also establish a solo 401-K or solo DRAC. Such DRAC's allow for much higher annual contributions than do IRA's. For these two reasons, Roth accounts are becoming a potentially attractive retirement planning device for high income people as well as for some of those who meet the traditional restrictions.

Roth conversion accelerates the recognition of ordinary income to the tax year of conversion, with one exception. For tax year 2010 only, the converter will have the right to defer the payment of that income tax and to split it between the following two tax years, that is, 2011 and 2012. This may reduce the marginal tax rate paid by the converter, spreads out the tax pain, and is the preferred way to go from a present value perspective.

As a rule of thumb, if there are ten or more years remaining until you plan to take any distributions from your IRA account, and if you expect your marginal tax rate in retirement to be rather high, then a Roth IRA re-characterization may make sense. Another reason for conversion might be if you wish your retirement savings to be passed on to the next generation.

Member of Congress reportedly hoped, in enacting the Roth conversion reform, to create current tax revenue on monies that would otherwise stay locked in traditional IRA's for many years, until either death (the ultimate tax event) or gradual taxation as RMD's begin. You might argue with the gimmick; younger savers will now have the opportunity over time to make huge profits on their contributions without ever paying any tax on those gains. Maybe Congress is being short-sighted. On the other hand, from a saver's point of view, the conversion under the proper circumstances can be truly compelling.

To analyze rigorously whether a Roth IRA conversion makes sense for you, your investment advisor should provide a spreadsheet future value analysis based on certain assumptions that you help provide. The assumptions would include long-term annual rate of return on your investments, amount of conversion tax, date of retirement, timing of distributions and tax rate at time of distribution. Given these premises, you will be able to see which plan will give you a greater final value after tax. As people become more aware of this opportunity, there will be a flood of Roth conversions, particularly in 2010.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

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