Considering a Roth Rollover?

Introduction

The Roth IRA (Roth) is a non-taxable money machine: income is accumulated and distributed tax-free, and it may be left to your heirs. Starting in 2010, taxpayers may rollover a traditional IRA into a Roth without previous income restrictions.

The rollover is generally taxable at ordinary income rates, but the resulting tax may be averaged over two years (2011 and 2012).

As of September 27, 2010, employees with 401k or 403b accounts may make a Roth conversion, provided their employers allow it.

Distribution Rules

Distributions are tax-free if they occur after age 59.5 and the contributions, including rollovers, have remained in the Roth for at least five years. If this requirement is violated, earnings generated from the contributions are taxable.

Also, if the owner is under age 59.5, there is an additional 10% penalty for early withdrawal.

IRA Comparison

Distributions from an IRA are taxable and mandatory after age 70.5. Once distributions commence, the pay-out period becomes fixed; consequently, an IRA may become a depleting resource.

In contrast, the Roth distributions are tax free and there are no compulsory distributions during the owner’s life. If an owner over age 70.5 lives another twenty years, and allows a Roth to accumulate, it could double or triple in value, while during that same time period, an IRA may have been drained by mandatory distributions.

Decision Points

The key Roth rollover considerations involve whether a taxpayer: (i) is willing to pay a hefty tax now for uncertain, but potentially substantial, benefits down the road; and (ii) has the cash outside of retirement plans to pay the tax. In my experience, the answer to both inquiries is often “no,” so in the end, a Roth rollover is not feasible for most taxpayers.

Nevertheless, if you are healthy, in a high tax bracket, have sufficient cash outside your retirement plans and do not need the funds immediately, a Roth rollover may make sense. The basic gamble is that your income taxes will increase substantially in later years and receiving tax-free income from a Roth is worth the tax-cost of conversion.

Also, if IRA assets have diminished in value and you expect them to rebound over the long term, converting now means paying a smaller tax, with the post-rollover appreciation shifting to the Roth.

Disadvantages

Clearly, the biggest disadvantage is paying taxes currently for an arguable prospective benefit. The funds used to pay Roth rollover taxes may be needed in subsequent years for support or medical expenses.

In some circumstances, maximizing taxable income may be desirable, especially when large deductible medical expenses may reduce taxable income substantially.

Conclusion:

If you have the stomach to pay taxes now for an unpredictable, but potentially significant, future benefit and you have cash resources independent from your retirement plans to pay the taxes, consider a Roth conversion in 2010.

Keep in mind that, moving forward, your actual tax rate may not be lower and you may incur substantial medical or other deductible expenses that could offset taxable income generated by a traditional IRA.

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