As an Investor Consider a ROTH IRA

[Goofyhobbie]

From the point of view of a middle class retiree, the Roth IRA has become for me the gold standard of retirement accounts.

Like most of us who planned ahead I contributed heavily into my former employer's thrift plan and then into that employer's 401-K plan when I became eligible. My savings have been modest over the years; but the principal and the investment gain in current dollars exceeds half of the total gross pay that was earned during my years of employment. Upon my early retirement in 2000 when I turned 55, those funds were moved to a Vanguard Rollover IRA.

It took me a while to realize it; but by late 2004 I came to the conclusion that I needed to start making relatively small conversions from my Rollover IRA to a ROTH IRA to avoid a heavy tax hit because of IRS forced minimum distributions when I turned 70 1/2.

So in December, 2005 I began to make those conversions to a Roth IRA.

Now, I want to share with you what has developed over the past five years.

IF opening a Roth IRA meets your needs and you have not set one up you may want to consider doing so sooner rather than later. Because I began conversions in December 2005, I can enjoy the proceeds of my Roth IRA NOW! NOT TAX deferred! NOPE! I can use the money as I see fit TAX FREE immediately. More on that later.

Each year I converted just enough to avoid moving me into the next higher tax bracket. Through the end of 2010 those relatively small conversions cost me ordinary income tax each year at my rather low tax rate; but the full tax bill on the full amount converted has been paid.

Fortunately for me, the investments chosen did well initially, dropped off a cliff in 2008, and have since fully recovered. To date the amounts converted (principal) are intact and the gains that the investments have created exceed 120% of the principal.

All of that gain is TAX FREE! Going forward the principal (X) plus the gain (120% of X)=s a pile that is more than 220% of the amount invested and it is 100% TAX FREE!

Assets inside a ROTH IRA can grow and be paid out income-tax-free if the taxpayer is the right age, and there are no mandatory distributions for the owner, as there are with regular IRAs.

Tax Free Roth payouts don't count in calculations for the alternative minimum tax, Social Security tax, Medicare premiums or the 3.8% investment income tax coming in 2013.

As you may have heard this is the first year that all taxpayers may convert other IRAs to Roth accounts regardless of their income. Many have jumped all over the opportunity to do it, even though that means paying ordinary income taxes on the transfer. But, if you do your conversions in relatively small increments each year you may find the tax bite to be affordable.

According to news reports Roth sponsors have experienced a surge;Vanguard Group is probably getting five times the number of conversions that they got this time last year.

A key Roth benefit that I personally took advantage of in 2008 is the ability for taxpayers who convert to reverse the transaction as late as Oct. 15 of the following year.

Yes, in late 2008 I re-characterized the conversion that I had made in early 2008 and increased the 2009 conversion dramatically because of the tax savings that the re-characterization provided. So, in effect my conversion plan did not miss a beat during the recession.

Going forward, I have taken advantage of another benefit of conversions over time. As the years have gone by, I have put different asset classes into separate Roth accounts and I will continue to do just that going forward because I can undo the ones that may lose value or have grown less within twenty to twenty-two months of creation.

For those of you who have not yet made a conversion in 2010 you have the option in 2010 ONLY to split the conversion income and report half in 2011 and half in 2012, paying taxes at then-current rates.

If the Bush tax cuts are extended, taking advantage of the deferral could make sense to some of you.

CAUTION: I am not a tax advisor, I simply do my own taxes and research. If you decide to act please consult your tax advisor.

Remember that Roth conversions work best when the following are true:

1) Your tax rate will be the same or higher in the future

2) Asset values have been higher than they are today

3) You have outside money to pay the tax

4) You can transfer assets without moving into a higher tax bracket.

Also, I have heard that in some cases, a conversion that raises income may help you avoid the alternative minimum tax.

As I stated earlier, even small conversions will start your five-year clock running. Once the five years is up, Roth payouts of both principal and earnings are TAX-FREE for those 59 ½ or older. If you are NOT 59 ½ or older only payouts of principal are tax-free until your five years is up.

Again check with your tax advisor; but I believe he or she will tell you that a late December conversion starts this clock running as of the previous January.

If you read this to late to do something in 2010, January is often a good time to convert to a Roth IRA, because doing so in January leaves the longest possible time to undo the conversion which is almost 22 months.

If you convert in January, 2011 you will have most of the upcoming Congressional term to decide whether or not to undo the conversion by doing a re-characterization.

Taxpayers, who convert in January, 2011 have until October, 2012 to undo the conversion. So, if you are concerned that Congress may change the rules after you have paid the taxes on a conversion, waiting until next year will give you until October, 2012 to undo the conversion.

REMEMBER: CHECK WITH YOUR TAX ADVISOR BEFORE deciding whether or not to convert to a ROTH IRA.

Source Information: IRS Publication 590

Vanguard on ROTH IRA

Smart Year End TAX Moves For Investors by Laura Sanders of theWall Street Journal Personal Finance


rothira.com

 

[Talent312]

Thaks for the primer, but I have one comment to make on taxable (non-Roth) conversions to Roth-IRA...

You will be subject to tax on the amount that you convert at your current tax rate. Even for fairly small amounts, you may well end up paying more tax on the amount converted, than if you waited and withdrew the $$ after retirement, when you may likely be in a significantly lower tax bracket.

... That's eggsactly why I'm waiting to close out a non-qualified annuity until after my DW retires next year...

 

[Goofyhobbie]

Talent312,

You are absolutely correct.

You will be subject to tax on the amount that you convert at your current tax rate.

If you feel that you will be in a lower tax bracket when you retire and you feel that any funds you take out of your retirement nest egg will not cause your tax bracket to increase then you should consider staying tax deferred. But, be aware that you will be sharing your investment gains with Uncle Sam when you start making withdrawals from your retirement kitty.

You have to ask yourself do you want your retirement to grow tax deferred or would you prefer that it grow TAX FREE.

I am convinced that taxes that I must pay will be going up over the next five years. My income will increase because of forced minimum distributions that start at age 70 ½.

I am trying to avoid paying any taxes much less higher taxes on my investment gains. That is why I am working so hard to convert as much as I can each year. Hopefully, by the time I am 70 ½ my kitty will have considerably less in a deferred account. Yes, I want my kitty to keep growing; but I prefer that as much as possible grow TAX FREE.

Since I was in the 15% tax bracket at age 60 in 2005 (five years after I had retired) it made sense to me to go ahead and start paying taxes at the 15% tax rate on all that I could convert without pushing myself into a higher tax bracket.

Each dollar that I ended up converting has continued to grow and in five years of accumulation each dollar has grown to two dollars and twenty-five cents. I have recouped all of the taxes paid and also doubled my investment. I will not have to pay Uncle Sam on the amount in the Roth today and I will not have to pay him on any subsequent gains that are produced within the Roth.

As you know at age 70 ½ we are forced to start depleting our retirement accounts. The IRS determines how much we must pay taxes on each month. I have managed to accumulate a big pile; but because I chose to convert some each year, the amount that will be taxable when tax rates go up will be considerably less than what would have accumulated in a tax differed account.

 

[geekette]

Roths are great, this is true. they are a very VERY nice savings vehicle. I think everyone should have one and start as early as possible.

But converting is not for everyone. really not a good option for us. The periodic conversion is a good tip, tho. Makes it feasible for more people.

I opted instead to begin a Roth that I have been funding faithfully all year. My paycheck can pay my 401k pretax and my Roth aftertax by direct deposit.

Some of the decision for me is based on having 20 more years in the workforce and a healthy 401k. I don't actually care about having to pay taxes on distributions on it because most of it won't be my money anyway, it's employer kick-ins and earnings. I of course reserve the right to bitch about the taxes when I do start taking the money out, but right now, it's fine with me!

My husband has a meager IRA that we will drain first when we start needing money, then my 401k/IRA, then, my Roth will be last.

I will have good flexibility in retirement to choose between taxable and taxfree income. I like having options when it comes time to settle up with Uncle Sam.

 

[Goofyhobbie]

geekette,

You have 20 years to think about it; but you might want to consider reversing your strategy for disbursements when you retire.

Between age 62 and 67 you may find it more tax efficient to draw down your Roth IRA savings first because all drawdowns from that account will NOT add to your INCOME for tax purposes.

Meanwhile, you might want to consider converting your husband's IRA to a Roth IRA a little each year. Given that you have two decades to grow your gains wouldn't it make more sense to you to grow those gains TAX FREE instead of tax deferred?

By converting sooner rather than later you should benefit from the relatively lower taxes that are or should be in place over the next two years.

The deficit you and others will have to pay down ten to 20 years from now is going to make today's deficit look like peanuts.

 

[geekette]

actually, since we can draw from DH's IRA now (he's past 59.5), no point in converting - no matter what we do we pay the tax man. We're not sitting on a bunch of cash, it would be significant to pay taxes and would most obviously come from the converted money which makes it a bad idea.

I expect I will revise over and over again my strategy since today's situation is no indicator of tomorrow's! I doubt I will ever quit working (so long as it remains fun) and prob'ly won't ditch the full time job until mid-60s and delay SS until 70 to get the max. So much depends on so much else that it's all subject to a lot of change. Repeatedly.

We also need the tax break now. While I'm working, 401k is awesome salary offset while monies put into DH IRA give us the 1040 deduct AND we can take the money out whenever we need it if we run into some big disaster that eats emergency fund, etc. Possibly we can sit on it until he's 70.5, do the RMD and monies we take out can go into my Roth. My own little IRA > Roth conversion without the paperwork.

I'm struggling this year to keep us in our tax bracket and not bump to the next, so pumping into IRA is going to help more than contributing to Roth. I can do catch-ups to his but not mine.

I appreciate that you mentioned more than once that people need to consult their own advisors. I agree completely. Given the age gap in my marriage and disparity in career wages, my situation is not quite cookie cutter. People need to consider what it really means to them and their own specific situations.

BUT, I am a huge fan of Roth's and helped my nephew open and start funding one when he graduated hs last June. Just think if YOU had started a Roth with $100 when you were 18... (Not YOU, Goofy, but You, Gentle reader whoever YOU may be...)

I'm glad you started this thread. Roth's have been around a while but remain misunderstood. And a lot of rules changes the last couple years.

 

[Dave M]

I'm struggling this year to keep us in our tax bracket and not bump to the next....

I just want to be sure there is no misconception here. Normally the only valid reason for deferring income to next year to avoid a higher bracket is if you expect to be in a lower bracket next year.

Assume, for example that you have 2010 taxable income of $68,000 (the top point of the 15% bracket) and your tax is $9,362.50. If you make another $100, moving you into the next higher (25%) tax bracket, you will only pay $25 more in tax - the tax on that additional $100. The tax on the first $67,900 of taxable income won't be any higher just because you move into a higher bracket.

You can prove this by looking at the 2010 tax rate schedule on page 267 of IRS Publication 17 for 2010. You'll see that the additional tax when you move into a new bracket is only on the income that is in that higher bracket.

Bottom line: Don't worry about trying to stay within a particular bracket under normal circumstances.

 

[Talent312]

Of course it makes sense to put taxable draws at the bottom of the list and pull from tax-free accounts, at least until both spouses are retired and presumably, their tax-rate is lowest. But there may be times when taking a taxable distribution first is not a bad idea.

We did that last year, when we were able to offset the additional income with a substantial capital loss. The trick was to draw no more than the loss we were able to claim. We had to pay more tax than we would have otherwise, but we were well able to absorb it... perhaps more so than if we'd been retired.

 

[John Cummings]

I just want to be sure there is no misconception here. Normally the only valid reason for deferring income to next year to avoid a higher bracket is if you expect to be in a lower bracket next year.

Assume, for example that you have 2010 taxable income of $68,000 (the top point of the 15% bracket) and your tax is $9,362.50. If you make another $100, moving you into the next higher (25%) tax bracket, you will only pay $25 more in tax - the tax on that additional $100. The tax on the first $67,900 of taxable income won't be any higher just because you move into a higher bracket.

You can prove this by looking at the 2010 tax rate schedule on page 267 of IRS Publication 17 for 2010. You'll see that the additional tax when you move into a new bracket is only on the income that is in that higher bracket.

Bottom line: Don't worry about trying to stay within a particular bracket under normal circumstances.

I used to hear people say all the time that they wouldn't work extra hours, etc. because it would put them in a higher tax bracket. I would tell them that the higher bracket only affects the marginal income above their normal earnings but they just refused to listen.

 

[geekette]

While I do know it's only the additional above that mark, we're likely to blow it away this year so have to be mindful of owing more tax on those dollars than our normal set-aside. In future years it won't be so significant since we'll have the withholding correct from the start so we can come out about even on withheld vs owed. That is always our goal.

I say YES to additional income, but, just have to consider the impact on settling up with Uncle Sam, and choose to offset as much as possible. our normal tax life is not challenging, there are just complicating factors this year.

There also are reasons to be mindful of AGI as certain things are/are not available to us depending on which side of the AGI line we're on.

 

[Gary]

Build their inheritance

Thanks for the good review of Roth's benefits, all!

I thought I would share one other use of a Roth: to fund our kids' inheritance. I have two sons in their mid twenties, and since they have been working, I have been funding a Roth in each of their names to the tune of $2000 a year (technically a gift). We do pay taxes on this, but are still in the 15% bracket ourselves.
We opened the accounts with our others at Schwab, and keep all the paperwork and investment decsions ourselves. The guys know these exist, but are not tempted to take the money out. The growth in value is untaxed, and with compounding, they should have a good nest egg when they retire. I believe that there are other life events for which they also can take money out.
I consider this essentially an inheritance for them. (And maybe they'll be able to pay maintainence fees with it!)

 

[#1 Cowboys Fan]

Can you fund one for me, too, Gary? :hysterical:

Hey, where in the Pine Tree State do you live?

Pat

 

[3kids4me]

A Roth makes no sense for us at all as there is no way we will be in a higher tax bracket after retirement than we are now. If I were in my 20s and in the 15% tax bracket, I would fund one in a minute. Right now I'm concentrating on anything that reduces our tax burden while generating income for use either now or in retirement, which of course includes a 401k. Unfortunately my company does not match; however, they provide a "safe harbor" contribution at the end of each year (amount at their discretion, and it varies by employee, so in a sense it is another type of bonus). You must be at the company five years to be fully vested in it; however, the amount given does not depend at all on how much of their own dollars one does or does not contribute.

 

[stevedmatt]

A Roth makes no sense for us at all as there is no way we will be in a higher tax bracket after retirement than we are now. If I were in my 20s and in the 15% tax bracket, I would fund one in a minute. Right now I'm concentrating on anything that reduces our tax burden while generating income for use either now or in retirement, which of course includes a 401k. Unfortunately my company does not match; however, they provide a "safe harbor" contribution at the end of each year (amount at their discretion, and it varies by employee, so in a sense it is another type of bonus). You must be at the company five years to be fully vested in it; however, the amount given does not depend at all on how much of their own dollars one does or does not contribute.

FWIW, you may not be in a higher income bracket, but the tax rates will likely never be lower than they are now so even being in the same bracket may cost you more tax in the future.

 

[lily28]

I am confused regard the conversion to roth ira. I have both deductable ira set up before roth ira and non-deductable ira set up the past few yrs when my income exceed that needed for roth ira. If I want to convert to roth IRA, can I choose to convert only the non-deductable ira since I already paid most of the taxes on it already, or do I need to covert equal portion of deductable and nondeductable IRA?

 

[IngridN]

I am confused regard the conversion to roth ira. I have both deductable ira set up before roth ira and non-deductable ira set up the past few yrs when my income exceed that needed for roth ira. If I want to convert to roth IRA, can I choose to convert only the non-deductable ira since I already paid most of the taxes on it already, or do I need to covert equal portion of deductable and nondeductable IRA?

You can't cherry pick and convert only the after tax IRA. We're in the same situation. DH also has a before tax IRA and converted only the after tax one thinking no taxes...we'll have to pay taxes on almost all of the conversion because the tax calculation is based on the total value of all of his IRAs. Mine on the other hand is all tax free, except for the gains :hysterical: as I only have 401k's as well as an inherited IRA which do not count in the calculations. There are on-line calculators you can use to estimate your tax hit.

 

[3kids4me]

FWIW, you may not be in a higher income bracket, but the tax rates will likely never be lower than they are now so even being in the same bracket may cost you more tax in the future.

There's a lot of debate surrounding that supposition when it comes to earners in high tax brackets. It's hard for me to imagine that we could ever get to a point where the federal government is taking over 35% of my income if I'm in the lowest or even second lowest bracket upon retirement, which is what would have to happen if your prediction above came true. I suppose anything is possible, but I just don't think it's probable.

 

[PigsDad]

There's a lot of debate surrounding that supposition when it comes to earners in high tax brackets. It's hard for me to imagine that we could ever get to a point where the federal government is taking over 35% of my income if I'm in the lowest or even second lowest bracket upon retirement, which is what would have to happen if your prediction above came true. I suppose anything is possible, but I just don't think it's probable.

I don't know how many years you have to retirement, but I am about 20 years away. I think there is a very good possibility that my tax bracket will be higher than my current bracket due to two main reasons. First, we have been very diligent on saving for retirement, so there is a good chance our income level will be higher than the bottom 1 or 2 tax brackets during retirement. Second, I see taxes going nowhere but up in the future. The more I can get into a ROTH now, the better.

We had a couple of non-deductible traditional IRAs that were completly funded with after-tax dollars. We converted those to ROTH this year, and it was a no-brainer. Since we only had to pay taxes on the earnings, and they were still recovering from the stock market drop, that was minimal.

Now I have another option to explore. Our 401k now offers the option to contribute to the traditional 401k (pre-tax dollars) or, new for this year, a ROTH 401k (post-tax dollars). Contributing to the ROTH 401k will definitely hurt the paycheck (more taxes taken out each time), and may also affect the limitations on deductions when we do our taxes as our AGI would be much higher w/o the pre-tax 401k contributions taken out of our AGI. I think I need to talk to a financial consultant to figure out what would be the best for our situation.

Kurt

 

[John Cummings]

There's a lot of debate surrounding that supposition when it comes to earners in high tax brackets. It's hard for me to imagine that we could ever get to a point where the federal government is taking over 35% of my income if I'm in the lowest or even second lowest bracket upon retirement, which is what would have to happen if your prediction above came true. I suppose anything is possible, but I just don't think it's probable.

I was in a similar situation prior to retiring. I have a pretty high retirement income but it is 1/3 of what I earned prior to retiring so I don't see my tax rates ever getting close to what they were.