Roth or not to Roth? Deciding requires predicting your future tax rate

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More employers now provide the option of a Roth 401(k) as well as a traditional 401(k), so you may ask:

Which should contribute to a Roth 401(k) or a traditional 401(k)?

The answer is not so simple and it depends on your income tax rate now and at retirement. Before offering background and explanation, we start with this Quick Summary

If you have a high tax rate now, and expect a low tax rate later, pick the traditional 401(k)

The traditional plan is better because get the current tax deduction, reducing taxes now at the higher tax rate. This may be true for people in middle or later years of employment.

Note: this is only financially better if you invest the amount of taxes saved.

If you have a low tax rate now, and expect a high tax rate later, pick the Roth 401(k).

The Roth plan is better because you avoid higher taxes later. This may be true for most people starting work now.

If expect to have the tax rate later as you have now, pick the Roth 401(k)

The Roth plan has other benefits described below.

Background – How the Plans Work:

Tax deferred growth

Earnings on both the traditional 401(k) and the Roth 401(k) are not taxed. Not paying taxes on investments in your retirement account means more grows and compounds tax-free – that is why contributing to a retirement plan is so important.

Contributions “pre-tax” vs. after tax

Contributions to a traditional 401(k) are made “pre-tax,” meaning that the amount contributed is excluded from your taxable income for the year.

Contributions to a Roth 401(k) are made after tax – they are not excluded from taxable income.

Taxing withdrawals vs. no tax

Withdrawals from a traditional 401(k) are taxed in the year of withdrawal.

Withdrawals from the Roth plans are not taxed. That is, the after-tax contributions are not taxed a second time and neither is the growth on those contributions.

Other rules – early withdrawal and require minimum distribution

There are penalties for withdrawal before reaching age 59½, unless certain exceptions are met, such as disability or first-time home buyer.

You must begin withdrawing when you reach age 70½ under the IRS Required Minimum Distribution or “RMD” rules. For more on RMD rules, see IRS Retirement Topics – RMDs

Hedging your bets:

If you are not sure of your tax rates, or if you just want more options because you cannot predict, then you can opt to combine plans. For example, you can contribute to your traditional 401(k) up to the employer match and then put the rest in a Roth IRA, if the contribution limits allow.

Conversions:

When you change jobs, you can convert a 401(k) to a Roth IRA, but doing so is a taxable event. If you expect your tax rate to be higher in the future, this is a good move. However, you will want to pay taxes due from other sources. If you have to take funds from the IRA to pay the taxes, you reduce the amount going into the Roth IRA which dramatically reduces the future benefit.

If you convert after-tax contributions made to a traditional 401(k) or non-deductible IRA, you have less on which taxes are due because the after-tax portion is not taxed in converting to a Roth IRA.

Other considerations:

While a Roth 401(k) is subject to RMD, a Roth IRA is not. If you can re-characterize the Roth 401(k) to a Roth IRA, you avoid the RMD. This may mean that you pass more on to your heirs. Also, you may gain investment flexibility compared to a company plan.

If you use a Roth plan, then your taxable income at retirement will be less than if you were withdrawing from a traditional plan where withdrawals are taxed. This could lessen tax due on social security benefits.

On the other hand, if you expect to use funds in your retirement plan to donate to a charity, you are better off getting the tax savings for yourself now. The charity is not subject to much if any income tax.

Also, if you expect your heirs to receive your retirement plan assets and know that those heirs will be in a lower income tax bracket, you should use a traditional plan now to get the tax benefit for yourself. How can you possibly determine that heirs will get more of your retirement than you and also be in a lower tax bracket? I cannot imagine – well, maybe I can, but none of the ideas sound good. Anyway, it seemed like a good idea to mention (they teach you to think this way in law school).

Update on Roth conversions – to do or not to do?

In deciding whether to convert your traditional IRA to a Roth, there are many factors to weigh. At present, uncertainty about potential income tax reform makes the decision even more difficult: you are making a decision on what provides greater tax advantages, conversion or not, without confidence in the future tax impact.
Nonetheless, converting makes good tax sense if you expect your future marginal tax rate in retirement to be the same or greater than the rate on the conversion. However, if you expect your tax rate in retirement to be lower, then you will pay more taxes on conversion than you will in retirement.
There are other reasons to consider converting now:
> First, converting an IRA or other plan to a Roth account means that the assets are no longer subject to the Required Minimum Distribution (“RMD”) requirement reached at age 70½, thus allowing you to retain assets as long you wish. At death, your heirs must start withdrawing from the account, but the withdrawals will be income tax-free.
> Second, if you believe your IRA assets will grow significantly over time then it is advantageous to convert. If you convert now, you will have a lower conversion rate (less of the total will have been subject to income taxes). This calculation applies whether your current IRA assets are depressed or have yet to appreciate.
There is a reason not to convert now:
> If you’re single and the conversion puts your AGI over $200,000 (or you’re married and the conversion puts your AGI above $250,000), then the 3.8% Medicare surtax on unearned income may be triggered. However, you can avoid this (and other unintended consequences) by doing partial conversions over multiple years.
What if you err? If you convert and then your account value falls, you have until October 15th of the following year to undo the conversion, thus revering the income taxes paid.
Planning: If you’re considering a conversion, give us a call and we can help you make the right decision for you!

Roth IRA, to convert or not to convert?

The answer depends on your tax rate now and expected tax rate when you plan to take withdrawals. Also, you should consider this only if you can cover the taxes with funds from outside of your IRAs, otherwise you are forfeiting the tax deferral on those funds.

For example, someone with a low tax rate now, from large losses, large deductions or low income, may have less in taxes to pay now so that the rate of tax is less than what it could be in the future, making converting a wise financial move.

As a separate matter, the taxes can be paid over two years, however, if you expect a higher rate for 2011, the interest you earn will not make it worth waiting.

Someone with high taxes now, or in the AMT, would be a bad candidate for converting.

If you are considering this and want more analysis, we created a tool for that purpose so let us know.

Tax Planning – take the IRA distribution or defer?

Here is another year-end tax planning issue for people taking the required minimum IRA distributions:

Do you defer as the 2009 law allows or do you take it now because tax rates will be going up?

Input from Kiplingers is reprinted below.

For me the issue is alternate sources of cash flow. If you can defer, even against rising rates, that usually pays off because of the compounding of sheltered growth

However, this depends on how you have invested as well as your cash flow needs so everyone has to review

Thanks,

Steven Contact

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To Tap or Not to Tap Your IRA

You can skip your distribution this year and save on taxes.
By Mary Beth Franklin, Senior Editor, Kiplinger’s Personal Finance
November 25, 2009

If you are at least 70½ years old, you normally must take a taxable distribution from your traditional IRA or employer-provided retirement plan by the end of the year — whether you need the money or not — or face a stiff penalty equal to half of the amount you failed to withdraw. But this year is different. Uncle Sam says you can skip your required minimum distribution for 2009. (Employees who continue working past age 70½ are not subject to mandatory distributions from their company plans until they retire, but they still must take distributions from their IRAs.)

IRA owners who turned 70½ between July 1 and December 31 would normally have to take their first distribution by April 1, 2010. But thanks to the waiver, they can skip that, too, delaying their first mandatory-distribution deadline until December 31, 2010.

Related Links

* The New Roth Rollover Rules

And if you tapped your IRA earlier in the year and now regret it, the usual 60-day rollover period, which allows you to redeposit the money tax- and penalty-free, has been extended to November 30. But there’s a catch: You are allowed to put one IRA withdrawal back into the account within 365 days. So if you received regular distributions every month, for example, then you can put only one of the withdrawals back in. If you received the money in a lump sum, however, then you can put it all back (including any taxes withheld from the distribution; otherwise it will be considered a distribution and will be taxed as ordinary income).

The one-year moratorium on mandatory distributions also applies to owners of inherited IRAs and other retirement accounts. For example, if you inherited your mother’s IRA and planned to take annual distributions based on your own life expectancy, you can forgo this year’s withdrawal. Or if you follow another set of distribution rules that require you to empty an inherited IRA by the end of the fifth year after the owner’s death, you now have an additional year to do so.

Although there are no required minimum distributions for Roth IRA owners — regardless of age — nonspouse beneficiaries who inherit a Roth are subject to the mandatory distributions. They can skip this year’s withdrawal, too.

Of course, you can tap your traditional IRA this year if you wish and pay taxes at your ordinary rate on the entire amount you withdraw. But if you don’t need the money, there are several advantages to skipping a distribution for 2009. Keeping your money invested in a tax-deferred IRA will give your account even more to time to recover from the worst market collapse since the Great Depression. Plus, not taking an IRA distribution this year could reduce the tax bill on your other income. You might be able to trim the amount of your Social Security benefits that are taxed, and with a lower income, you may be eligible for other tax breaks that you normally can’t use, such as deducting medical expenses in excess of 7.5% of your adjusted gross income.

You can still opt to send up to $100,000 of your IRA distribution directly to a charity. While you can’t double-dip and deduct the donation as a charitable contribution, the amount will not be added to your taxable income.

Another option: Because you aren’t required to withdraw the money this year, you may want to roll some of it into a Roth IRA. (See more on Roth IRA choices here.) You’ll have to pay taxes when you make the switch, but you can take tax-free withdrawals after five years, you never have to take required minimum distributions, and you can create a tax-free inheritance for your heirs. You don’t need earned income to convert a traditional IRA to a Roth, but to qualify, your income — not counting converted amounts — can’t top $100,000 in 2009.

Tags: Roth IRAs and Roth 401(k)s Making Your Money Last, Saving for Retirement, Tax Breaks, Tax Planning

Let us know if you have questions or comments. Thanks,

Steven

To convert or not – traditional IRA to Roth IRA …

Converting a traditional IRA to a Roth IRA results in current income taxes. Also, certain taxpayers with high income cannot avail themselves of converting

If you have money outside your IRA that can cover the taxes, you are more likely to want to convert the IRA. The reason for doing so is that no taxes are due on withdrawals during retirement. Also, the asset passes to heirs with no income tax.

However, you are trading the taxes now, lessening your total investments, for future taxes. So you need to work through the decision to convert carefully

The calculation is complicated and, for example, if the traditional IRA were to be subject to taxes at a lower rate than now, converting might make sense.

A list of concerns appears below. If you are considering making this conversion and want help with the decision, let us know.

Thanks,

Steven

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First, Bob Keebler is a CPA with a major accounting firm, Baker Tilly, in Appleton, Wis., and author of The Big IRA Book. Here’s his reaction to the article:
“The math of the conversion is more complex than this author addresses:
• When rates are going down the conversion likely makes no sense.
• When rates are going up the conversion is more likely to make sense.
• Conversions are likely better for the person who does not need the funds to live off.
• Conversions are generally better for the person that has outside funds to pay the taxes.
• Conversions for a couple before the first death can make sense.
• Conversions with the intention to monitor the market often make sense.
• Conversions for a person with an estate tax problem will make more sense than for a person without an estate tax issue.
• Conversions to leave a Roth to grandchildren often have merit.
• Conversions for a person with an NOL or other carryforward can make sense.
“This question is very complex and a calculator cannot replace the professional’s judgment.”