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).

Roth Conversions – decisions on 2010, recharacterize now or pay taxes over two years?

You can still decide as late as October 15th (if you extend filing of your tax returns) to either recharacterize or pay the taxes in 2011 and 2012 instead of on your 2010 taxes for your 2010 conversion to a Roth IRA.

Recharacterize – if you have the misfortune of losing value on the IRA after converting, you can “un-convert” by “recharacterizing” the Roth IRA as a traditional IRA using an IRA-to-IRA transfer (do not distribute funds to yourself, as that distribution voids the recharacterization). You can do this for all or a portion of the account. Once you do so, you cannot convert again until later of 30 days after the recharacterization or the year after the year of the original conversion.
This strategy is useful to address a decreased IRA value or to shift the conversion into future years with less income, so you are in a lower tax bracket.

Tax payments
– 2010 is the only year where you can choose to have the income of the conversion split in half and carried onto your 2011 and 2012 tax returns. This (1) spreads the time to come up with funds to pay the taxes (you never want to use the funds in the IRA as that defeats the purpose) and (2) gives you earnings on funds already available to pay the taxes until the payment due date.

Note: if you are paying taxes on the conversion with your 2010 taxes, the amounts are due April 18, 2011, even if you extend to have the option of recharacterizing. If you do recharacterize, then you will have over paid and have a refund due …. until you convert again.

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.”