Roth IRAs to Expand, With Big Tax Benefits

Nov. 10, 2009 — -- Most people hate to pay taxes -- and if you hate paying them now, wait until they start going up. You're sure to hate them even more.

That's why now is the time to give serious consideration to converting at least a portion of your retirement savings into a Roth IRA, one of the best defenses against potential future increases in federal and state income taxes.

With the Roth IRA, there's no tax savings on the front end as with other retirement savings accounts, but it allows for years of tax-free growth followed by withdrawals in retirement that are entirely free from taxation. Imagine paying no income tax in retirement.

Roth IRAs can be funded by annual contributions or a conversion from existing retirement accounts.

If you convert to a Roth IRA, you pay taxes upfront on the conversion amount in return for avoiding income taxes down the road. The hope is that the future tax savings will far outweigh the cost of conversion.

The Roth IRA has been around in this form for years, but a change set to take effect Jan. 1 will allow more taxpayers than ever to enjoy its benefits.

On that date, individuals and couples who make more than $100,000 a year will be eligible to convert existing savings now sitting in a traditional IRA or some other retirement plan to a Roth IRA. Currently, such conversions are restricted to those under the $100,000 income level.

This elimination of an income cap for conversions will primarily benefit higher-income taxpayers who have been cut off from the Roth's benefits, but there's something in it for lower-income individuals as well.

A special 2010 incentive provided by Congress will allow anyone who converts to a Roth next year to delay paying taxes on the conversion and spread them out over the 2011 and 2012 tax years.

Few Investors Aware of Roth Tax Changes

This one-year deal -- aimed at providing a temporary boost to federal tax revenues -- applies to everyone, regardless of income.

What this all means for individual investors is that they will be hearing a lot about Roth IRA conversions over the next 13 months. There will be a nonstop stream of advertising and media coverage discussing both the pros and cons of Roth IRA conversions.

The basic question for individual investors is whether the upfront tax costs of conversion will pay off in the long run. There's no easy answer to that question, and it's different for every taxpayer.

That may be why so few individual investors realize what's happening in 2010.

A survey in August by Fidelity Investments found that nearly 90 percent of individual investors were unaware of the 2010 Roth conversion opportunities. The survey also found that a high percentage of investors lack a basic understanding of how Roth IRAs work. For instance, 66 percent of the respondents to the survey incorrectly thought that withdrawals from a Roth IRA must begin before a person reaches age 70-and-a-half. (That is true of conventional IRAs.)

In fact, one of the Roth's great benefits is there no requirement for minimum withdrawals at a certain age as there is with a traditional IRA or most other retirement savings accounts. This makes it a great vehicle for investment assets someone wishes to leave to their children or other heirs.

"It was amazing to me how folks were uncertain of the benefits of a Roth IRA," said Chris McDermott, Fidelity's senior vice president of investor education, retirement and financial planning.

His company is gearing up to spend more time on the conversion issue with its investors in the year ahead, discussing both the advantages and disadvantages.

"It's not as cut and dry as people might think," McDermott said.

In general, a Roth IRA conversion can make sense in situations like these:

The account owner is young and has many years until retirement. This allows for years of investment growth to overcome the upfront taxes paid on the conversion.

The taxpayer has cash in a nonretirement account to pay the taxes owed. In many cases, using funds from the retirement account being converted to pay the taxes eliminates the eventual tax savings.

The investor is in a low tax bracket now, but expects to be in the same or higher tax bracket in the future. This could be true in the case of a person laid off during the recession or out of work for some other reason. In this situation, the taxpayer comes out ahead by paying taxes at a lower rate now and avoiding future taxation at a higher rate.

Benefits of Roth IRA Expand

These are but just a few examples of the situations where a Roth IRA conversion can make sense.

On the flip side, it may not make sense if an investor is earning a high income now and expects to be in a lower tax bracket in the future, or if there are no nonretirement funds available to pay the taxes associated with the conversion.

For someone considering a large Roth IRA conversion, it makes sense to seek out the help of a tax advisor or a financial planner to avoid an unhappy tax surprise. But as a starting point, there are numerous online calculators available that help taxpayers run their own numbers.

Calculating Tax Savings

A new calculator unveiled by Fidelity last week is the best one I've seen yet: http://www.fidelity.com/rothevaluator. It makes it easy for investors to plug in their own information and then play around with different scenarios.

What I liked about it in particular is that it showed why, in many cases, it makes sense to convert a portion of your retirement assets to a Roth IRA, rather than all of them.

If your conversion is large enough, it could push you into a higher tax bracket and cause you to owe more than you expected, erasing the benefits of conversion. Often, it is best to break down the total conversion into smaller amounts over several years.

The Fidelity calculator shows what might be the optimum conversion amount in a given tax year.

It showed me that a husband and wife, both 45, an income of $150,000 and $200,000 in retirement savings, would be better off converting $40,000 in 2010 rather than the full $200,000. In this case, the couple would utilize the 2011-2012 tax deferral option and would come out ahead on taxes by nearly $17,000.

Making the most of the Roth conversion opportunities that begin Jan. 1 will take some effort, but the long-run savings could be considerable. Give it some thought.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.