With the end of the year approaching and many investors holding underwater assets in traditional retirement accounts, this is a good time to consider whether to move some of those holdings into Roth accounts.
Here’s a run-down on the differences between the two account types:
- Traditional accounts, such as individual retirement accounts (IRAs), 401(k)s or other employer-sponsored plans, are funded with pre-tax money, either deposited from salary into a qualified employee plan before taxable income is figured or deposited into an IRA and claimed as a tax deduction. No tax is paid on money deposited, earnings on the account (dividends or interest) or gain in value until the money is withdrawn. Account holders must make minimum required distributions (MRDs) from the account once they reach 70 ½. All money withdrawn or distributed is taxed at the account holder’s ordinary income tax rate, plus a 10 percent penalty for individuals who haven’t yet reached 59 ½ and don’t otherwise qualify for an exemption.
- Roth accounts are funded with money on which any taxes due were paid before deposit, such as earnings taxed as income, gifts, inheritances or settlements. No tax is due on withdrawals from Roth accounts as long as the money deposited is kept in the account for at least five years and the account holder is at least 59 ½ years old (or meets exemption requirements like hardship or other conditions enumerated by law).
Money held in traditional accounts (including IRAs and, for the first time this year, 401(k)s or other kinds of qualified pension, profit sharing or stock bonus plans) can be converted to Roth accounts either by transfers, roll-overs or redesignations. In a transfer, the account holder directs the trustee of the traditional plan to deposit some or all of the plan assets into the Roth account. In a rollover, the account holder receives the money from the traditional plan and then is responsible for depositing it into a Roth account within 60 days. If the traditional and Roth accounts are held by the same trustee, the account holder can simply tell the trustee to redesignate the entire account as a Roth.
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After the money is transferred, the account holder includes the conversion amount in income for the year in which it was distributed from the traditional account. Because it is being deposited into the Roth account, individuals who haven’t yet reached 59 ½ don’t have to pay the 10 percent early-withdrawal penalty.
As a general rule, individuals who expect to be in a higher or the same tax bracket when the money is withdrawn would do better to pay the tax now and put the money into a Roth account. However, there are several other considerations.
- Holding money in a Roth account essentially shelters it from tax on any appreciation in the account value. The first consideration is whether the assets you would transfer, or those you would invest in through the Roth account, are likely to appreciate in value over the next few years. You may have a broader choice of investment options by setting up a self-directed Roth account.
- If you don’t believe your assets will be worth more in the future, you need to consider whether the earnings (such as dividends, interest, rental or other income) will likely be high enough to benefit from the conversion. This consideration weighs the tax you incur in the conversion year against the tax you would pay on the appreciated account when you withdraw the money.
- The greatest potential for growth occurs when funds from taxable accounts not included in the rollover are used to pay the taxes, according to John Corn, investment adviser with Buckingham Asset Management. Having to take some of the tax money out of retirement accounts may counter the advantage gained from the conversion.
- For the 2008 and 2009 tax years, there continues to be an income cap on Roth conversions. They are available only to individuals and couples filing joint returns with modified adjusted gross income (AGI) below $100,000, not including the amount converted or any RMDs taken from traditional retirement accounts. You need to be able to estimate your 2008 income to decide whether to make the conversion by year-end.
- Beginning in 2010 the income cap will no longer apply. Taxpayers who convert traditional accounts into Roth accounts in the transition year (2010) will be able to stretch their tax liability on the conversion over two years, with half due in 2011 and half in 2012. In essence, this operates like an interest-free loan from the government for the amount of your tax liability. For some people, it may be more advantageous to wait.
- Individuals who have low income this year but high charitable deductions or medical expenses, losses carried forward or other tax-favored items can boost their income by converting some traditional retirement account assets to Roth, Corn noted. Not only would they get the benefits of conversion, but by forcibly increasing their income through the conversion, they can take advantage of all their qualified deductions and credits, he said.
- Tiya Lim, investment strategy manager for the Buckingham Family of Financial Services, noted that an additional bonus comes from converting assets to Roth accounts at the end of the year. The conversion is considered to have taken effect on January 1 of the year in which it is made, and this effectively reduces the five-year waiting period for withdrawals to four years.
As always with technical and tax-related techniques, investors would be well advised to check with their investment and tax advisers before deciding whether to convert traditional retirement assets to Roth accounts. Considering the short timeline between now and the end of the year, however, also note that mistaken conversions can be recharacterized up until the due date of your tax return, including extensions. That means you have until October 15, 2009 to undo any mistakes.