To Roth or not to Roth: 7 tips to help you answer

More wealthy investors have been converting since 2010

By Robert Cirrotti

Apr 14, 2014 @ 3:16 pm EST

Roth IRAs have been available since 1997, but changes in recent years to the U.S. Tax Code have made these retirement savings accounts more popular than ever. According to the IRS, 10% of all IRA holders with annual incomes of more than $1 million converted their IRAs to a Roth Account in 2010, which was the first year with revised income limits. The basic question is simple: When do you want your tax savings, now or in the future? With apologies to the playwright, here are some tips for thinking through the choices.

Shakespeare's investment tip No. 1: What's in a name?

A Roth IRA is an individual retirement plan, established by the Taxpayer Relief Act of 1997 and named for its chief sponsor, Sen. William Roth, in which an individual makes retirement contributions with after-tax dollars.

Many believe that Congress will continue to favor Roth-like options because taxes must be paid immediately, not delayed until funds are taken as distributions. Federal tax revenue projections are based on 10-year periods that cause Roth contributions to be looked on with greater favor than deferred-tax-savings incentives. The Obama administration's recent MyRA idea is basically a Roth IRA in a different wrapper with restricted investment options. On the flip side, future tax proposals are likely to lead to scrutiny of current Roth benefits, such as allowing money to remain in a Roth IRA indefinitely without the minimum required distributions of traditional IRAs.

Shakespeare's investment tip No. 2: See first that the design is wise and just

Before deciding to convert some or all of your retirement savings from a traditional IRA to a Roth IRA, consider the potential impact of a variety of financial strategies on your present and future savings.

Which tax-planning strategy makes the most sense; pay taxes now or later? This is important because a Roth IRA may be more appealing to those who believe their tax bracket will increase by the time they make withdrawals, either because of increases in federal tax rates or because the individual's income will grow. Still, funds must be available now to pay any taxes associated with the conversion to a Roth IRA.

Since qualified Roth distributions are not counted as earned income, they avoid the potential of triggering higher taxes due by reaching Social Security tax thresholds and higher modified adjusted gross Income for Medicare Part B premiums.

Finally, consider the impact a Roth IRA conversion may have on your estate plans and the transfer of wealth from one generation to another. For example, with Roth IRAs, you may plan for gift and estate planning by leaving money to heirs in an income tax-free account. And, because Roth IRAs don't require minimum required distributions at age 70� like traditional IRAs, these accounts can potentially grow larger, leaving more money for your heirs.

This table shows how the Adjusted Gross Income (AGI) affects the contribution limits to a Roth IRA by filing status.

Shakespeare's investment tip No. 3: Men (and women) at some time are masters of their fates

Thanks to recent changes in the tax code, the advantages of Roth IRAs now extend to even larger numbers of individuals.

To make a Roth IRA contribution, the investor must have earned income in a particular year from salary, hourly wages or profits from a small business. Income and contribution limits are set by the federal government and may not be higher than those illustrated in the accompanying chart. In addition, if an individual's earned income is less than his or her eligible contribution amount, the maximum contribution amount is the individual's income.

At the same time, investors are allowed to convert (or change the designation of) a traditional IRA to a Roth IRA regardless of their income. This does not trigger any penalty typically imposed on early withdrawals and does not affect eligibility to open other Roth IRAs.

Keep in mind that partial conversions are available — it's not an all or none situation. Roth conversions are treated as taxable income and could move you into a higher income tax bracket. If that is a concern, consider a partial conversion — converting just enough of the traditional IRA to remain in the current income tax bracket. Then accomplish additional conversions in subsequent years.

Remember, too, that if you earn too much money to contribute to a Roth IRA, you might instead consider making a nondeductible contribution to a traditional IRA that may be converted later to a Roth IRA. However, keep in mind that other IRA assets may affect the effectiveness of this strategy. it's wise to speak wtih a tax professional or a financial advisor about these questions.

Shakespeare's investment tip No. 4: To thine own self be true

Among the many reasons why you should consider opening a Roth IRA or Roth 401(k):

• Contributing at any age. Roth IRA contributions may be made at any age, providing the individual has earned income, while traditional IRA contributions can only be made up to age 70�.

• Not requiring distributions. Currently, individuals are not required to take distributions from a Roth IRA, whereas traditional IRA accountholders must start withdrawing money at 70�. However, this feature is under scrutiny by Congress.

• Availability to nonworking spouses. A nonworking spouse can open a Roth IRA based on the working spouse's earnings or the couple's joint tax filing status.

• Complementing other savings programs. Individuals may contribute to a Roth IRA even if they participate in an employer-sponsored retirement plan.

• Avoiding Medicare surtax. Roth distributions don't count toward the modified adjusted gross income threshold that determines the surtax for Part B premiums.

• Reducing estate value. Because taxes are paid in advance, a Roth IRA may also reduce the value of a person's estate by lowering the estate value below the estate tax threshold and may even eliminate certain estate taxes.

• Subject to certain restrictions, individuals can switch their IRA contributions from one type of IRA to another, or undo a conversion (which is known as a recharacterization). This can be done to recover ground from an earlier decision that performed poorly or because an investor simply changes his or her mind.

Shakespeare's investment tip No. 5: There is nothing either good or bad, but thinking makes it so

Consider a number of potential disadvantages to Roth IRAs. For instance, because all contributions are taxed immediately, you need to be able to pay the cost of converting a traditional IRA to a Roth IRA. Ideally, this should be done by using funds outside of an IRA, such as cash reserves.

Tax laws are, of course, always subject to change, especially when it comes to things like new tax rates, new or increased taxes on certain benefits and potential VAT implications. So keep in mind that a wise strategy today may not be a wise strategy tomorrow.

Before opting to open a Roth IRA or make a conversion, you should consult a professional tax adviser. And you should not wait until late December to place the call. By then, the tax adviser may be overwhelmed with requests for assistance and it may be too late to do whatever is required to facilitate the most beneficial — and least expensive — conversion during that calendar year.

Shakespeare's investment tip No. 6: The golden age is before us, not behind us

Some people settle on the idea that, as is so often true in investing, the wisest idea is to diversify your strategy: Keep some assets in traditional IRAs and some in Roth IRAs -- of which Shakespeare might have said, “though it be but little, it is fierce.”

Robert Cirrotti is head of retirement solutions for Pershing, a BNY Mellon company.

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