Roth IRAs

What is a Roth IRA and why is it such a great deal?

Since its introduction in 1998, the Roth IRA has been a popular alternative to a traditional IRA. Here's why:

• Tax-free withdrawals. Instead of claiming a tax deduction up front, as one would with a deductible contribution to a traditional IRA, a Roth IRA offers tax-free withdrawals on the back end — as long as you leave the money in the fund for at least five years and are 59½ or older when you take distributions or experience another qualifying event, such as death, disability or purchase of a first home.
• Tax-free growth. Although you won't receive a tax break in the year that you make a conversion or contribution to a Roth, your money can grow tax-free once it's in the fund.
• No required minimum distributions. Unlike a traditional IRA which requires withdrawals beginning at age 70½, a Roth IRA has no required minimum distributions. So you can keep your money in the fund indefinitely and have complete control over when and how much you withdraw. And remember — withdrawals are tax free.
• Estate planning opportunities. A Roth IRA conversion can reduce the size of your taxable estate. In addition, because there are no required minimum distributions, you can eventually pass the full value of your Roth on to your heirs, free of income taxes. Non-spouse beneficiaries can continue to accrue tax-free growth in an inherited Roth IRA, but they must take required distributions based on their own life expectancy.

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What are the expanded Roth IRA opportunities for 2010?

Beginning this year, everyone is eligible for a conversion regardless of their level of income. The $100,000 modified adjusted gross income limit to be eligible to convert a traditional IRA or qualified plan to a Roth IRA is repealed.

This may be great news for higher-income individuals and couples, who until now have been unable to convert an existing IRA or employer-qualified plan to a Roth. Also effective this year, a conversion to a Roth IRA is allowed regardless of filing status. Previously, married taxpayers who filed separately were not allowed to make a Roth IRA conversion.

When you convert your traditional IRA to a Roth, you are choosing to pay tax today on the amount you convert. This is important. You are accelerating the payment of taxes, telling the IRS, "Tax me today instead of in the future." This is why converting to a Roth is a big decision. Of course you would only convert if you thought you would pay less tax today than you would pay if you did not do the conversion and instead paid the tax at some point in the future when you withdraw money from your traditional IRA.

When you convert your traditional IRA, the amount you convert goes into a Roth IRA where it will enjoy tax free growth and, importantly, you will enjoy tax free withdrawals. So when you choose a Roth Conversion, you are accelerating the payment of taxes in exchange for being able to put your IRA funds into an environment where they will never be taxed again.

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What's so great about diversified sources of retirement cash flow?

Retired clients of Bragg know that we think it is desirable to be able to manipulate your taxable income in retirement. Retirement cash flow is not the same thing as taxable income. Wouldn't it be nice to have a lot of retirement cash flow but very little taxable income? Retirement cash flow drawn from a pre-tax IRA is 100% taxable as ordinary income. Retirement cash flow drawn from your joint account or other non-IRA may be lightly taxed (perhaps a little capital gain and some dividends). Retirement cash flow drawn from a Roth IRA is 100% tax free. Because the future tax environment is uncertain, we think it makes sense to have the choice to draw from different "pots" of money and therefore be able to control or manipulate your taxable income. Obviously it would be great to have 100% tax-free retirement cash flow, but because most folks have large pre-tax IRAs, that is often difficult to achieve. We can take incremental steps toward having diversified sources of income by exploring the Roth conversion.

When considering the Roth, we think it makes sense to take a measured approach. Congress can always change the law, modifying or eliminating some of the benefits already discussed in this article. We think it makes sense to be in a position to fare well, regardless of current law. Just as a diversified portfolio is prudent, having diversified sources of retirement income makes sense as well.

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How do I know if a conversion is the right choice for me?

As a rule of thumb, a Roth IRA conversion makes sense if you:

1. Have a long period of time until you need to access the funds (you need to hold the Roth IRA for at least five years before you can distribute any earnings tax-free but generally a longer period of time is necessary for the conversion to be advantageous);
2. Are in a lower tax bracket now than you will be when you or your beneficiaries access the money; and
3. Have assets available outside your IRA to pay the conversion taxes.

At Bragg, we think the most important of these is item number 2 above. If you are contemplating a conversion, it is important that you are fairly confident that you will pay a lower rate of tax on the amount you convert than you would pay if you did not convert and simply drew the money and paid taxes at some date in the future. If you are not confident that this is the case, we would be cautious about rushing into a Roth conversion. We suggest reading this paragraph several times.

If you change your mind or your circumstances change, you can re-characterize your Roth IRA conversion back to a traditional IRA for any reason until Oct. 15 of the year following the conversion year and have no tax consequences. This gives you flexibility in the event the value of your investment declines after you convert or if your situation changes to the point where the Roth conversion no longer makes sense. Please note that there are specific tax filing rules to follow if you wish to re-characterize your conversion.

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What are "conversion taxes"?

Because a Roth IRA conversion involves moving assets from a pre-tax IRA or qualified plan to a Roth IRA, the amount converted is subject to ordinary income tax. One potential advantage to converting in 2010 is that you can report income from the conversion on your tax return for the same year, or you can divide it equally on your 2011 and 2012 tax returns. This may make it easier to come up with the funds to pay the tax and depending on your situation, it may result in a lower tax bill. Your tax advisor can help you decide whether spreading the tax makes sense.

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Should I contribute directly to a Roth IRA?

If you qualify, YES! This is an option; however, one thing that isn't changing for the Roth IRA is the income limitation for people who make direct contributions. The income threshold for 2010 is $120,000 (phase out begins at $105,000) for single filers and $176,000 (phase out begins at $166,000) for married couples filing jointly. For individuals who are not eligible to make a Roth IRA contribution or deductible IRA contribution, funding a non-deductible traditional IRA and converting to a Roth IRA in 2010 (or later years) may be a good strategy. There are special tax rules associated with after-tax IRAs, so be sure to check with your tax advisor before utilizing this strategy.

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I do not qualify to contribute directly to a Roth. Why should I consider making after-tax contributions to a traditional IRA?

Making non-deductible or after-tax contributions to an IRA is a back door route to funding the Roth IRA. Because anyone can now convert an IRA to a Roth IRA, you can simply convert your non-deductible IRA to a Roth IRA. It seems silly but it works. Do this each year you are eligible. Please note that this strategy is less attractive for folks who already have a large pre-tax traditional IRA. You are not able to convert the after-tax portion alone. Instead the converted amount is based on the overall IRA balance and the taxable portion is the pro rata share of the overall balance.

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Should I contribute to a Roth 401k at work?

Your employer may offer a Roth 401k in addition to the traditional pre-tax 401k. If so, you can choose to contribute to either plan or to both plans but your combined contribution for 2010 can not exceed $16,500 ($22,000 if you are over age 50). Whether to contribute to the pre-tax 401k or to the Roth 401k really depends on your specific tax circumstances. You might choose the Roth 401k over the pre-tax 401k if you think that you will be in a higher tax bracket when you draw the funds out than you are in today. This may be the case for a lot of young folks just starting out with relatively low salaries. You might choose to do the Roth 401k because you already have a lot of pre-tax money and you wish to diversify your future sources of retirement cash flow. See "What's so great about diversified sources of retirement cash flow?" in the above section.

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