Consider a Roth IRA for Tax-Free Income

This Q&A answers essential questions about adding a Roth account to your nest egg.

Tax-free money: It's a dream of every investor. And that's what the Roth IRA can deliver. The downside, of course, is that you must pay Uncle Sam income taxes on the amount you put into a Roth account, whether you contribute directly or convert a traditional IRA. Still, adding a Roth to your nest egg is worth a close look.

The benefits are big, starting with compounded tax-free growth. You can generally withdraw the money during retirement without having to pay income tax. And Roth IRA owners never have to take required minimum distributions, as you must starting at 70 1/2 with traditional accounts. Even for older investors, "Roth IRAs have a very viable place in a financial plan," says Ken Moraif, a certified financial planner at wealth-management firm Money Matters, in Plano, Tex.

One advantage for older investors: By converting part of your traditional IRA to a Roth, you can reduce the size of required minimum distributions from your traditional IRA. You could be in the 15% bracket now, but if you have a large traditional IRA, you could end up in the 28% bracket when you're required to take withdrawals, Moraif says.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Also, because you never need to take RMDs, a Roth IRA could be the ideal place to hold the aggressive investments of your portfolio, says Christine Fahlund, senior financial planner for T. Rowe Price. These investments, such as growth stocks, can grow tax free, unencumbered by withdrawals.

Moreover, the pot of tax-free money provides flexibility when it comes to your annual tax bill. You can draw on this tax-free income stream if you are in danger of exceeding income thresholds that will trigger certain taxes or that will disqualify you from taking certain tax credits or deductions. For example, instead of having 85% of your Social Security benefits taxed, you could perhaps lower the percentage to 70% by taking some of your income from a Roth, says Fahlund.

Also, a Roth IRA could be a good source of money to cover a major unexpected expense. If you need $15,000 to replace your roof, that withdrawal from a tax-deferred account could push you into a higher tax bracket. "You have a place to go get extra money," Fahlund says.

Kiplinger's Retirement Report reader Margaret Kearney, 71, and her husband, Bill, 72, who live in Lake View, N.Y., have been doing small Roth conversions for a number of years. By spreading out the conversions, they've kept their tax bills reasonable. Kearney says a big attraction of the Roth is the amount of control the couple can have over the money. "You decide when to let it grow, when to take a distribution and at what price and for what reason," says Kearney. "If we have large expenses, we have Roth assets to tap without being additionally stung by a big tax bite."

No matter how old you are, a conversion could make sense. But many experts say it's best to convert money that you don't plan to use until later in retirement or that you never expect to spend. This gives the money time to grow tax free. "As a rule of thumb, the longer you can defer withdrawals, the greater the benefit," says Ken Hevert, vice-president of personal and small business retirement products at Fidelity Investments.

You can set up a Roth by converting a traditional IRA or by making after-tax contributions to a Roth IRA. Many employers now offer Roth 401(k) accounts. You can convert all or part of your regular 401(k) to a Roth or make contributions to it, or both.

The Roth rules are complex. The following answers the essential questions about adding a Roth account to your nest egg.

How much can I contribute each year to a Roth? You must have earned income to be able to contribute to a Roth IRA, but you can contribute at any age (the cutoff is 70 1/2 for traditional IRAs). If you are 50 or older, you can contribute up to $6,500 for 2013 and 2014. However, you cannot make contributions if your income exceeds certain limits. For 2013, the eligibility to contribute to a Roth IRA phases out at $188,000 for married filers and $127,000 for singles ($191,000 and $129,000, respectively, for 2014).

If your company offers a Roth 401(k), you can contribute up to $23,000 for 2013 and 2014 if you are 50 or older. Roth 401(k) contributions for 2013 must be made by December 31, but you have until April 15, 2014, to make 2013 Roth IRA contributions.

If I no longer have earned income, can I still open a Roth? You can, by converting your traditional IRA to a Roth. And unlike contributing to a Roth, there are no income limits for doing a conversion. However, the money you convert will be added to your taxable income for the year, and you will owe income tax at your ordinary rate. To count for 2013, you must convert traditional IRA money by December 31.

You don't have to convert your entire IRA. By converting smaller amounts over several years, as the Kearneys did, you will keep the tax bill smaller. Say you have a $100,000 IRA and you'd like to convert $50,000. You might convert $10,000 a year for five years.

One strategy is to convert enough money to take you up to the top of your current tax bracket. A married couple in the 15% tax bracket in 2013 with $39,500 of taxable income could generate another $33,000 of taxable income before hitting the next bracket of 25%. "Try to use up lower tax brackets," says Mike Piershale, president of Piershale Financial Group, in Crystal Lake, Ill. "It's a lot cheaper to do a conversion at the 15% tax bracket."

Besides pushing you into a higher tax bracket, a large conversion could trigger taxes that are imposed when adjusted gross income exceeds certain thresholds, such as taxes on Social Security benefits. You also could find yourself above the AGI threshold that triggers the new 3.8% surtax on investment income. And if your AGI spikes, you could end up paying premium surcharges for Medicare Part B and Part D. Those surcharges will only last a year, though, if your income drops in the year after you convert.

How do I decide if I should do a Roth IRA conversion? Your projected tax rate is the key for deciding whether a Roth conversion might make sense. If you expect your tax rate to be higher in the future, paying the tax on traditional IRA money now at a lower tax rate can be beneficial, says Paul Jacobs, chief investment officer in the Atlanta office of Palisades Hudson Financial Group.

[page break]

A taxpayer who expects to remain in the same tax bracket can also benefit from a conversion. The tax would be the same whether it's paid now or later. And the conversion will create a pot of tax-free income.

Those who expect their tax rate to be lower in future years should wait to convert. Say you are in the 25% tax bracket now, but you will drop to the 15% bracket when you retire in a couple of years. Convert now, and "you would lose 25 cents on the dollar instead of 15 cents on the dollar," Piershale says.

Before deciding to convert, make sure you have money outside the traditional IRA to pay the tax bill. Otherwise, you'll be creating another tax bill if you withdraw the tax money from the IRA.

Is there a way to convert without paying taxes? It's almost impossible. Low-income seniors whose standard deduction and exemptions (a maximum of $22,400 in 2013 for a couple both age 65 or older) exceed their taxable income can convert the difference tax free. "Figure out how much in wasted deductions you have, and then convert that amount to a Roth," Piershale suggests.

Part of a conversion can be tax free if you have made nondeductible contributions to your traditional IRA. But there's a catch: You can't simply move that after-tax money to a Roth tax free. Instead, you must determine the ratio of after-tax contributions to the total balance in all your traditional IRAs, including tax-deductible contributions and earnings. Say you have made $10,000 in nondeductible contributions to IRAs that hold a total of $100,000. If you convert $10,000 to a Roth, only 10% of the conversion will be tax free.

Can I convert my required minimum distribution from my traditional IRA? No. Required payouts cannot be converted to a Roth. In fact, once you reach age 70 1/2, the first money out of a traditional IRA each year is considered your required distribution. Only after you have satisfied the payout requirement can you convert remaining assets to a Roth. The RMD is taxable, of course, and can be used to pay the tax on a Roth conversion.

How long do I have to wait to take tax-free withdrawals from my Roth IRA? There are different rules for contributed money, converted money and earnings. Because you must pay tax on contributions going into a Roth IRA, those direct contributions can be withdrawn at any age and at any time free of taxes or penalties.

To tap earnings tax- and penalty-free, you need to meet two conditions: You must be older than 59 1/2, and you must have had at least one Roth IRA for at least five years.

If you have never opened a Roth IRA, there's a good reason to create one—via contribution or conversion—before the end of the year. The clock on the five-year holding period starts ticking on January 1 of the year you opened the account. If you are, say, 58 now and you convert an IRA to open your first Roth in December 2013, you can begin to tap Roth earnings tax free in January 2018. Wait until January, and you will have to wait until 2019 to withdraw earnings tax free.

There is a separate five-year test for converted money. Taxpayers age 59 1/2 or younger must wait five years before they can withdraw a converted amount free of the 10% penalty. Each conversion has its own five-year period for this purpose. (The goal is to prevent the use of a Roth conversion as an end-run around the 10% early-withdrawal penalty for pre-59 1/2 payouts from traditional IRAs.)

Once you turn 59 1/2, that 10% penalty disappears. So the 58-year-old in the above example only needs to wait a year and a half to dip into the converted amount penalty free, though he must still wait the rest of the five years for withdrawn earnings to be tax free.

Account holders who want to tap Roths usually don't need to worry about withdrawing earnings too soon. Under IRS order-of-withdrawal rules, the money you take from a Roth is first considered to come from direct contributions, then converted amounts, and only after both have been depleted, earnings.

Can my heirs benefit from my Roth IRA? Estate planning is one of the major reasons that older taxpayers consider Roth conversions, especially for those who don't expect to ever spend the money. If you leave the Roth to a child or grandchild, all the money in the Roth goes to the heir free of income taxes and the account can be stretched over the heir's own life expectancy. "When grandkids inherit a Roth IRA, they will have tax-free growth for the rest of their lives," says Moraif. It is "one of the best financial gifts you can give to a young person." (The Roth is still included in your estate for estate-tax purposes.)

Nonspouse heirs are required to take minimum distributions from inherited Roth IRAs starting the year following the owner's death. However, if the Roth was your first Roth and you die before you've met the five-year holding period, earnings won't be tax free for heirs until that test is met.

A surviving spouse can choose to remain a beneficiary of the account or can take the Roth as his or her own. A spouse who does the latter would not be required to take minimum distributions.

Using a Roth conversion as an estate-planning tool has another benefit for wealthy taxpayers. "You're reducing the size of your taxable estate when you pay conversion taxes," says Fahlund.

If you plan to leave your IRA to charity, do not convert the account. The charity would owe no taxes on the traditional IRA, so by converting it you would be paying Uncle Sam unnecessarily.

Will I owe state income tax if I convert? Yes, unless you live in one of the nine states that does not tax ordinary income. If you plan to move in retirement, consider how your new state's income tax rate stacks up to the tax rate in your current state. If you are moving from a state that taxes income, such as Connecticut, to a state that doesn't, such as Florida, wait to convert until after you move. (Check out Kiplinger's Retiree Tax Map.)

What if I decide the IRA conversion was a mistake? "There is the undo button if it turns out the conversion strategy didn't pan out as expected, or you don't have cash to pay the tax bill," says Fidelity's Hevert. You can undo a Roth IRA conversion—known as a recharacterization—up until October 15 of the following year.

Recharacterizing is a good idea if the account value has dropped since you converted. If you converted $50,000 in 2013, but the account value later drops to $35,000, you will still owe tax on the $50,000. Reverse the conversion by October 15, 2014, and you will wipe away the tax bill. "It's as if nothing ever happened in the first place," says Jacobs.

Even if the account value doesn't drop, you may want to undo the Roth IRA conversion if you can no longer afford the tax bill on the conversion. Or you might want to reverse it if the conversion ends up pushing you into a higher tax bracket than you thought you would be in.

Consider splitting your conversion into multiple Roth IRAs divided by asset class. That way, you can reverse the conversion only on accounts that have lost value. Say you split your Roth conversion into two: One Roth holds stocks, and the other holds bonds. If your bond Roth loses value but your stock Roth gains value, you can leave the stock Roth alone and just recharacterize the bond Roth.

Be aware that if you convert a 401(k) to a Roth 401(k), you cannot undo it. However, you could convert that 401(k) money into a Roth IRA—that will allow you the option to recharacterize that money into a traditional IRA.

Rachel L. Sheedy
Editor, Kiplinger's Retirement Report