Saving for Retirement
Switching to a Roth Makes Sense Now
Pay Uncle Sam upfront and get tax-free income in retirement.
By Mary Beth Franklin, Senior Editor
From Kiplinger's Personal Finance magazine, September 2009
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OUR READER
WHO: Mark Crossler, 46
WHERE: Eugene, Ore.
QUESTION: What's a good strategy for dealing with the likelihood that my tax bracket will go up?
During his long commutes to work, Mark, a marketing professional from Eugene, Ore., likes to listen to personal-finance books on his iPod. His aha moment came when he realized that many of the tax breaks that he and his wife, Sandy, enjoy -- deductions for interest on their mortgage and home-equity loan; deductions for contributions to his 403(b) retirement plan; the $1,000-a-year federal tax credit for their son, Jacoby, 7; and the state income-tax deduction they get for contributions to Jacoby's 529 college-savings plan -- will disappear when they retire and pay off their mortgage. So even after they stop working and saving, they could still land in a high tax bracket.
And that bracket may be moving higher. As federal and state budget deficits grow, so do concerns that tax rates will rise. That makes moving money from a traditional IRA to a Roth look like a smart strategy. "Roth IRA conversions are the silver lining to the economic crisis," says IRA expert Ed Slott, a CPA in Rockville Centre, N.Y. "These may be the lowest tax rates you'll see for the rest of your life. And with account values down, it's a double sale."
Mark and Sandy started transferring money from traditional IRAs to Roth IRAs last fall after the stock market collapsed. Before the end of 2008, they also sold some investments they held in taxable accounts, locking in losses to offset future capital gains and generating cash to pay the taxes on the Roth IRA conversions. (If you use IRA funds to pay the tax, you'll incur additional tax and possibly pay a 10% early-withdrawal penalty.)
The Crosslers' $25,000 Roth conversion cost them an extra $5,700 in combined state and federal taxes in 2008, but they think it was worth it. "As the market rebounds, we'll have the added benefit of all that money growing tax-free for the rest of our lives," says Mark.
Wait till next year
To qualify for a Roth conversion in 2009, your adjusted gross income can't exceed $100,000, whether you are single or married. If your income is too high, be patient. Income limits on Roth IRA conversions disappear in 2010, so anyone can convert to a Roth IRA. Better yet, if you wait until then, you can spread the tax bill over two years, splitting it between your 2011 and 2012 tax returns.
Part of Mark's motivation is to have more control over taxes in retirement, when Roth withdrawals are tax-free. "We can withdraw enough taxable income from our traditional retirement accounts to keep us in a low tax bracket and then supplement our income from our Roth IRAs," says Mark.
That strategy makes sense, although the couple may not want to tap their Roth accounts quite so soon, says James Lange, head of James Lange and Associates, a financial-planning group in Pittsburgh, and author of Retire Secure (Wiley, $24.95). For instance, if you want to leave a legacy to your heirs, a Roth IRA trumps all other accounts, says Lange. There are no mandatory-distribution requirements, and your beneficiaries can inherit the account tax-free.
Reader Comments (18)
Posted by: Allie at 08/11/2009 08:52:33 PM
There is mandatory distribution requirements for a Roth other than a spouse though at time of death. So sometimes money given outside of IRA money before death (some each year) is sometimes more beneficial to the heirs. They can pay off house etc faster.
Posted by: Peter at 09/13/2009 04:24:24 PM
Can you convert some in 2009 (as long as Ajd. Inc is below $100K) and then convert more in 2010? And, can you pay some of tax hit of 2010 coversion in 2010 and then spread the rest over 2011 and 2012?
Posted by: Owen at 09/15/2009 11:18:02 PM
I am over 59 and 1/2 years old. I need to withdraw $50,000 from a traditional IRA in 2010 for living expenses. I will owe $12,500 in income taxes attributable to the withdrawal, regardless of when the $50,000 is included in my income for tax purposes (I am assuming Congress will act to keep the 25% tax bracket when the Bush tax cuts expire). As I understand the rules, I can convert $50,000 of my TIRA to a Roth IRA early in 2010, make withdrawals from that Roth IRA of $37,500 for non-tax expenses in 2010, and not have to include the converted $50,000 in my income for tax purposes until 2011 and 2012 (one-half each year). Then, as I need to make estimated payments of the tax in 2011 and 2012, I can withdraw the amounts of the respective payments from the Roth IRA. Even though I will not have waited 5 years to make the withdrawals from the Roth IRA, those withdrawals will not result in any additional tax or penalty because I am more than 59 and 1/2 years old. In other words, I can delay paying income taxes on the $50,000 until 2011 and 2012, even though I have the benefit of the $50,000 in 2010 to the same extent as if I had withdrawn it from the TIRA in 2010. Granted, I will not be able to earn much on the delayed tax amount, but everything helps these days. Are there any holes in this approach?
Posted by: Jason M Blumer, CPA at 09/28/2009 11:14:58 PM
Peter - I don't know your total situation, but it probably would make sense to wait and convert all of your regular IRA to Roth in 2010, because you don't get the two year spread to pay your tax unless you convert your Roth in 2010 (so no need to convert some in 2009). The deal is convert in 2010, and spread the tax over 2011 and 2012. That's it. I'm not sure why you would want to pay some of that tax in 2010 (from converting on your 2009 tax return) when you could defer the payment to 2011 and 2012. Owen - There is one hole in your scenario. You have to have the Roth in place for at least 5 years (which you alluded to). There is no age limit on that rule. Anyone and everyone (and any age) must have a Roth IRA for 5 years or they will be taxed on the earnings. Those doing it before 59.5 will pay a 10% penalty, and those after 59.5 will only pay the tax. Check our my blog for a series I'm writing now on the Roth conversions: www [dot] THRIVEal [dot] com (look for the Tuesday Tax Time posts) Thanks, Jason M. Blumer, CPA
Posted by: William Bass at 10/04/2009 03:15:43 PM
It is the modified adjusted gross income (MAGI) that is limited to $100,000 (i.e.,, it doesn't include the amount if the traditional IRA converted to Roth IRA). This is often overlooked when doing the math.
Posted by: DAVID L. ZALLES, CPA at 10/05/2009 03:32:30 PM
Most articles incorrectly state that 1/2 of the taxes from the 2010 ROTH CONVERSION are paid in 2011 and 2012. Actually, 1/2 of the INCOME from the ROTH CONVERSION will be reported on the 2011 and 2012 TAX RETURNS, with the taxes payable the following 4/15 or 10/15 if extended.
Posted by: Mike Epperson at 10/11/2009 03:55:05 PM
Does it make sense to convert $1 million to a roth? We are both retired. I am 69 and wife is 66. That would sure be a lot of taxes to have to pay. Thanks...
Posted by: george at 10/27/2009 08:44:30 AM
I am waiting for a response on Mike Epperson's post.
Posted by: Mary Beth Franklin at 10/27/2009 12:00:57 PM
Hi, Mary Beth here, author of this article. Thank you, Mr. Zalles, for acknowledging that my article correctly states that the amounts converted to a Roth IRA are reported on the 2011 and 2012 tax returns due by April 15 2012 and 2013. While returns can be extended until Oct 15, you're still required to pay taxes owed by April 15.One note of caution: a large conversion could substantially boost your taxable income and make your vulnerable to underpayment penalties so you may have to file quarterly estimated tax payments in 2011 and 2012. Hope this helps.
Posted by: Mary Beth Franklin at 10/27/2009 12:06:24 PM
Hi Mike, Mary Beth Franklin here, author this article. In response to your question, it's impossible to say whether converting a $1 million to a Roth IRA is the right answer for you without knowing your full financial picture and your estate planning goals. Such a large conversion would probably put you in the top 35% tax bracket, costing you $350,000 in taxes. It makes most sense to pay those taxes from funds outside the Roth IRA. The new Roth account would be spared from taxes on future withdrawals, would not require annual distributions and can be left to your heirs tax free. The question is, do you have enough money to foot the tax bill and is it worth it too you? It doesn't have to be an all-or-nothing deal. Convert some of your money in 2010 and spread the tax bill over 2011 and 2012 (see my earlier post about quarterly estimated tax payments for large conversions). You can always convert more later, but only those amounts converted in 2010 benefit from the two-year spread to pay the tax bill. Hope this helps.
Posted by: Robert Smith at 10/29/2009 10:30:06 PM
Regarding Mike's question: is there a millionaire surtax in 09 or 2010? And is it not true that the second half of a IRA that is converted in 2010 and spread over two years will be subject to 2011 tax rates that could be higher than 09 or 10?
Posted by: Rob at 11/02/2009 01:25:25 PM
I was transferring funds from a Regular IRA to fund 2009 Roth the other day through Ameritrade. I thought I would be so smart and transfer some securities that I thought were under-valued. Transfer went smoothly and the securities appeared in my Roth account in just a day or two. Excellent, or so I thought. Tried the same thing with my wife's account, but the Ameritrade rep emailed back that securities could not be used to fund a Roth. Oops. Got any suggestions? PS. To add another layer of trauma. We're in Mexico until end of January so fax service is patchy although Skype connection is good. Wow!
Posted by: Larry at 11/05/2009 01:30:06 PM
Please clarify the concluding statement in your excellent article -- "your beneficiaries can inherit the account tax-free." Although we have no idea what federal estate taxes will actually look like post-2010, the balance of the Roth IRA will be included in the taxable estate of the owner and may be subject to estate tax -- but will be exempt from income tax. Is that correct?
Posted by: jason at 11/06/2009 12:31:31 PM
Re: Spread the conversion tax over 2 yrs after 2010. Assuming I am unemployed and received no income for 2010 and convert $180,000 of my IRA into Roth IRA. Does it mean the 28% of $180,000 in taxes, half of which due in 2011 and the remaining half due 2012? OR $90,000 (half of $180,000) is subject to my 2010 25% tax rate, the remaining $90,000 subject to my personal income tax rate of 2011 - if I become employed again, my personal income tax rate will be higher than 25%? Thanks.
Posted by: Al at 11/08/2009 03:40:17 PM
OK, I see that the income limits for a Roth conversion are being lifted for 2010, but what about income limits for future contributions? I have a small amount of after-tax contributions in an existing regular IRA, and it might make sense to isolate that after-tax amount by rolling over the larger pre-tax amount into my existing 401(k) plan,leaving the after-tax amount to stand alone. I could then convert the after-tax amount into a Roth IRA, but the big advantage would be if I could make yearly contributions of $5,000 to the new Roth for the next 5 years before I can make a withdrawal. However, to do this I need the contribution limits lifted for 2010 and beyond, and I can find no information on changed contribution limits. Does anybody know the answer and can they refer me to a source document?
Posted by: MSB at 11/15/2009 12:17:35 AM
Question re Roth conversion in 2010: For calculating pretax vs post tax contributions in the traditional IRAs before conversion to a Roth IRA (to determine tax liability) are the IRAs for the wife and husband combined together or are they calculated seperately for each individual's set of IRAs even though they file a joint return? Thanks!
Posted by: Donna B at 11/18/2009 11:03:59 AM
Can anyone help me with my questions - I am clueless when it comes to 401Ks, etc.? My husband and I are 55. We earn approximately $90K/yr. and presently have just over $100K in traditional 401Ks @ work. We have been considering transferring all of the 401K money to a Roth because of historical increases in income tax. Would this be a smart move or insane given our age and the amount of tax that would have to be paid on the transfer? Would we want to do it in 2009 or 2010? There are no state taxes where we live.
Posted by: Mary Beth Franklin at 11/19/2009 08:52:57 AM
Hi, Mary Beth here again, author of the article. In response to Robert Smith, if you convert to a Roth IRA in 2010 you have two choices: pay all of your taxes on your 2010 return (due April 15, 2011) when you are certain of your tax rate, or spread your tax half and half over your 2011 and 2012 returns (due April 15, 2012 and 2013) and tax the chance that your tax rate may be higher. Hope this helps.