Roths And Conversions
THE ROTH ADVANTAGE
The prime benefit of a Roth can be summed up in two words: tax free. Roth IRAs were created in 1998 to help encourage taxpayers to save for their own retirement. Their big enticement is tax free income in retirement. They are designed to benefit most anyone with an earned income, especially if they think they will be in the same or higher tax bracket in retirement.
KEY FACTS ABOUT A ROTH
Surprisingly few people understand the powerful features of a Roth account:
- Contributions are not tax-deductible
- Withdrawals are income tax free after age 59½ and a 5-year holding period
- Contributions can be withdrawn at any time; withdrawals of earnings are allowed only after age 59½ and a 5-year holding period
- A 10% penalty is assessed on early withdrawals
- You can contribute up until April 15 for the previous year
Tax savvy investors use Roths as much as possible to help pursue a brighter financial future
ARE YOU ELIGIBLE TO CONTRIBUTE?
Generally speaking, most people can find a way to benefit from a Roth. Eligibility rules for Roth contributions (not conversions, where everyone is eligible) are the same as for traditional IRAs, with these exceptions:
- No age restrictions for Roth contributions
- No required minimum withdrawals for Roth
- Withdrawals are tax free as long as Roth rules are followed
Anyone with earned income or a spouse’s earned income, either single or married, may contribute to a Roth, subject to income ceilings. [Strategy: if you make too much money, you can still make a non-deductible contribution to an IRA, and then convert it to a Roth] Opening a Roth IRA does not require a commitment for future contributions – most Roth accounts have very reasonable minimums. Contributions (not conversions) are subject to a limit depending on your age, your income, and the rules for that year. You also cannot contribute more than your and your spouse’s earnings. [Strategy: there is no limit to the amount of traditional IRA money to convert to a Roth]
ROTH WITHDRAWAL STRATEGIES
The important thing is to have worked out the strategy that gives you the best chance of paying the least amount of taxes over your lifetime, allowing you the highest potential income, and maximizing the amount you can pass to your heirs after you are gone. Since individual tax and investment situations vary substantially, this should be done on an individual basis with a competent Certified Financial Planner™.
A TAX-FREE LEGACY FOR YOUR FAMILY
One of the most compelling applications of a Roth conversion is that you can leave to your beneficiaries (your children, grandchildren, etc.) a lifetime stream of tax-free income. A beneficiary can elect to take only the minimum required distribution each year over their life expectancy. And all the income, as well as the principle, is completely tax free to your heirs.
For example, assume a 65-year-old couple has $100,000 in an IRA. They decide to convert that to a Roth and pay the taxes today so that they don’t keep accumulating. The first difference they notice is that at age 70½ they do not have to take their required minimum withdrawals. When the husband dies at age 80, the wife inherits the account and continues to allow it to grow tax free. She has no required minimum withdrawals either. By the time of her death 10 years later, assuming an 8% return, the account has grown to $739,635.32.
The account passes to their 60-year-old daughter who takes the required distributions until she dies 15 years later at age 75. The account then passes to her son, the original owner’s grandson, who continues to take the required minimum withdrawals until the account is used up.
By the end of the grandson’s life, the Roth has generated over $2.6 million dollars of tax-free income, compared to barely $1 million taxable dollars in a regular IRA. Tax-free investing in a Roth can be a very powerful way to create a legacy to pass to your children and grandchildren.
A Roth conversion simply means you change all or part of your traditional retirement savings over to a Roth. You move from “tax-deferred” to “tax-free” status. Beginning in 2010, just about anyone can convert all or a portion of their traditional retirement accounts into tax free Roth IRAs. The old limits on income have been eliminated.
Most retirement investors should at least consider a Roth IRA conversion. Of course, you will have to pay taxes on the amount you convert. Admittedly, that is a big hurdle for most investors to get over. But remember that you are going to have to pay them anyway – sooner or later. And many investors will consider it worthwhile to pay them now in order to get the tax-free future growth, tax-free withdrawals, exemption from required minimum distributions, and access to the many advantageous Roth strategies.