Recent articles have been writing about rolling over an IRA into a Roth IRA especially in 2010 when the exemption to convert an IRA to a Roth IRA for people making more than $100,000 is removed. Some of the reasons to covert to a Roth IRA include:
• Tax rates are bound to increase, thus it is better to get taxed now before they become higher
• Roth IRA account can be used as an emergency fund
• Payments from a Roth IRA do not need to begin at age 70½ unlike an IRA account; thus the Roth IRA account can continue to grow tax free
• Roth IRA income is not included in income test for determining if taxes are paid on Social Security income
Yet, is it this easy of a decision for everyone? No.
Income tax may actually be higher not lower due to converting to a Roth IRA. When considering what tax scenario is better for you, compare the tax rates under each scenario.
For Roth IRA rollover, the tax rate may increase to the next tax bracket because the amount converted is considered income. For example, a married couple earning $60,000 who decide to rollover $50,000 is normally taxed at 15% marginal tax rate on their $60,000 of income (for 2006). However, for the $50,000 of additional income due to the conversion, $1,300 would be taxed at 15% tax rate and $48,700 would be taxed at 25% under 2006 tax bracket. So the average tax rate paid on the rollover is approximately 24.7%.
If they kept their money in the IRA, the tax rate paid on the IRA in retirement could be the same or lower than their marginal tax rate at that time. For example, if the family has $20,000 in Social Security and $40,000 in IRA distribution, $85% of $20,000 Social Security benefit will be taxed at mainly 10% tax rate and thus the IRA distribution will be taxed at 15%.
Based on this basic calculation, being taxed at 15% from the IRA account in retirement is better than being taxed at 24.7% for the Roth IRA rollover. Taxes would need to increase by 66% on the 15% tax bracket in the future before the Roth IRA rollover breaks even (66% increase on 15% = 25%). So those who will be in the lower income brackets (about ½ of tax payers) may be better off not converting especially if the conversion means that most of their IRA is being taxed at a significantly higher tax bracket.
For those in a higher tax brackets (above 25%), the IRA/401(k) payment in retirement may be taxed at various rates (15%, 25%, 28%, etc.) and not necessarily all at the higher rates. For example, a single person earning $75,000 would be taxed at 28% or more on his Roth IRA conversion. Yet, if he does not covert and his IRA distribution is the main portion of his retirement income, the IRA would be taxed at various rates (15%, 25% and 28%) thus the average rate could be less than 28% tax rate on the Roth IRA conversion. Thus, it still may not make sense to convert.
Note, many Roth IRA conversion calculators only consider your current marginal tax rate and not these graduated tax rates. So be aware and be careful.
In addition, you should consider the state taxes that you pay. If you are in a high income tax state like New York or California and plan to move to a low or no income tax state like Florida, there are some benefits to deferring your taxes to retirement. Thus, you may want to avoid converting to a Roth IRA now because you will be taxed by the state you reside in at the time of distribution.
Reason #2: Roth IRA account can be used as an emergency fund
Technically a Roth IRA can be used as an emergency fund. However, this would not be the wisest decision for many in planning their finances. First, an emergency fund should not be invested in volatile assets like stocks or bonds. This is because if there is an economic downturn and you lose your job, these assets (especially stocks) can drop in price just as you need to liquidate them for your emergency. Thus, a Roth IRA invested in stocks and bonds (for retirement) may not be the safest emergency fund. It may be an extreme (backup) emergency fund, but not necessarily for a primary emergency fund.
Second, retirement assets are meant for retirement and are not to suppose to be used for other reasons. Many Americans are already not saving enough for their retirement, let alone if they liquidate their Roth IRA when an emergency comes up. In addition, if you withdrawal $20,000 from a Roth IRA for an emergency and can not pay it back in that year, you can not simply repay it in later years because you will be limited by the annual Roth IRA limits (currently $4,000 in 2006, $5,000 if over age of 50)
Reason #3: Roth IRA does not need to begin its payment at 70½ unlike an IRA account, thus the account can continue to grow tax free
This is a good idea for those who have other assets to use when they first retire or plan to leave a large inheritance to their children. Yet, because many families are not in this situation, many will have to tap into their IRA/401(k) when they retire instead of waiting until after age 70½. So this may not really that big of a benefit for many.
Reason #4: Roth IRA income is not included in income test for determining if taxes are paid on Social Security income
This is currently a benefit for having a Roth IRA. Thus, by having income from an IRA instead of a Roth IRA, it is easier to hit the earnings limit for being taxed on Social Security benefits (tax is phased in between $25,000 and $34,000 for singles and between $32,000 and $44,000 for married couples). Thus, having a Roth IRA may help you avoid paying taxes on your Social Security benefit which can offset the potential higher taxes paid in converting to a Roth IRA plan. Yet, before you think that Roth IRA is the way to go, there are two caveats.
First, Congress may change the rules for excluding Roth IRA in the Social Security income calculation test. Roth IRA was created in 1998 after Congress wrote the Social Security taxation rules in 1983 (and which were revised in 1993). Thus, as Roth IRAs accounts become a greater portion of retirement incomes, Congress may go back and revise the Social Security taxation rules to account for Roth IRAs. And, if taxes are supposedly going to increase (as others imply in the first reason to convert to a Roth IRA), do you really believe that Congress will allow this loophole to continue when people are converting their IRA to a Roth IRA (and 401(k) plans to IRA rollover plans to Roth IRA plans) to avoid taxes?
Second, the earnings limit for taxing Social Security benefits have been in effect since 1993 without being changing. Thus, due to inflation, these income limits will be easier and easier to meet whether or not you have an IRA or Roth IRA. For example, a new retiree with $30,000 of income today will be equivalent to $50,000 of income in 15 years (well over the income limit test) assuming 3.5% inflation.
So, if you are close to retirement, this may be an advantage if Congress does not change the laws in the short-term. Yet, if you are younger, this advantage may go away either due to inflation or due to Congress closing the loophole.
As a final note, if you are thinking about converting to Roth IRA, please pay attention to not only your current tax rates but also your estimated future tax rates. And, if your income including your IRA rollover is going to put you into a higher tax bracket, you may want to only consider a partial rollover (convert a portion each year) to avoid paying taxes in the higher tax brackets. And as always, you should consult a tax/financial advisor for a more information in regards to your particular situation.
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