Everyone with a traditional IRA should be looking into whether converting to a Roth IRA might make sense for them, because the ability to shelter future earnings from taxation is a very attractive feature of the Roth. The difficult part in doing a conversion analysis, however, is in forecasting the tax bracket that will apply when the IRA monies are distributed in the future. For alternative minimum tax payers, the Roth analysis can be especially difficult.

Roth IRA vs. traditional IRA

Contributions to a traditional IRA are tax-deductible when made, subject to income restrictions and other limitations. In return, distributions taken from the IRA, typically in retirement, are taxable, along with the earnings on the IRA while it was invested. For a Roth IRA, on the other hand, there is no tax deduction when the contributions are made, and in return there is no taxable income at the time of taking distributions. The feature particularly attractive to a Roth is that the earnings also are not taxable.

Roth conversions

Prior to 2010 there were income limits on who was allowed to convert a traditional IRA to a Roth IRA. These income limits prevented most folks who had the wherewithal to make such a conversion from being able to do so. The removal of these income limits has resulted in a lot of articles being written on this issue, and many investment advisers continue to meet with their clients to try to figure out whether or not a conversion sense for them.

The basics of a Roth conversion are simple. In exchange for paying taxes now, an individual will pay no taxes when the monies are withdrawn from the IRA. Sounds simple, yes, but the analysis actually is pretty difficult because of the variables involved, particularly the individual’s tax rates, both now and in the future.

Example

Assume an individual has a traditional IRA with a balance of $100,000, and has been able to deduct all of the contributions that have been made to it. If that individual is in the 35 percent tax bracket, electing to convert it to a Roth today will mean tax due of $35,000. The remaining balance of $65,000 will continue to be invested, and at retirement there will be no taxes due on the $65,000 or on any of the investment earnings. If one assumes investment growth of 50 percent between now and retirement, the individual will end up with a tax-free distribution of $97,500.

Compare this to leaving the IRA alone and not making the conversion. Fifty percent growth will mean the IRA will be worth $150,000 at retirement, before tax. If the individual is still in the 35 percent bracket, the tax will be $52,500, leaving a net amount for the individual of $97,500. How interesting, one notes – the result is exactly the same!

Tax planning for a Roth conversion

So now you know the "secret" behind the Roth conversion analysis – investment yield is irrelevant. The entire analysis is in the tax rates – what tax bracket you are in today vs. what tax bracket you expect to be in at retirement. With Republicans fighting Democrats over who is and who is not "rich," and continuous last-minute temporary "extenders" of our individual income tax rates it is, in fact, almost impossible to do with any degree of accuracy. But that doesn’t mean the analysis shouldn’t be done. Set forth below is all the information you need.

Page 1 of 2 :: First | Last :: Prev | 1 2 | Next