The benefits of Roth IRAs are undeniable: no required minimum distributions for an owner and, perhaps best of all, no income tax on qualified distributions.
For those investors who meet the income requirements to fund a Roth, choosing one is simple. Investors who exceed those limits but still want to access a Roth account can do so – if they prepare to manage the up-front costs.
Higher-income taxpayers have been able to access the Roth’s benefits by moving funds from tax-qualified accounts such as traditional IRAs and 401(k)s. But those conversions trigger income tax on the amount being shifted. While investors who opted for the Roth in 2010 had the opportunity to split the tax bill between their 2011 and 2012 returns, investors now must pay the total bill for the Roth conversion when they file the tax return for the year in which they complete the conversion.
Investors need to find the right option for paying their conversion taxes based on their financial goals, tax situation and other investments.
Be as deliberate in planning for how you will cover that tax bill as you are in contributing and investing the funds in your retirement account. Otherwise you risk undercutting the long-term benefits of a Roth.
As you and your financial adviser prepare to complete a Roth conversion, focus on how you could pay the taxes associated with that transaction in a way that supports the growth potential of your retirement savings.
Is a Roth right for you?
Tax rules that went into effect in 2010 made Roths available to most investors, but that doesn’t mean they’re right for everyone.
• Investors with long-time horizons typically reap the most benefits from a changeover because they have plenty of time to accrue enough earnings to offset the conversion taxes.
• Roths also tend to be a good choice for investors who expect to be in a higher income tax bracket during retirement. In such situations, distributions from a traditional IRA would be likely to incur a tax rate higher than the present cost of a conversion.
Every investor who chooses a Roth conversion needs to determine how to pay the tax – and tapping the retirement funds you’re converting in order to pay those taxes is risky. You’d be losing the potential for tax-deferred growth, which is what you’ve earmarked that money for instead.
Think outside the account
Rather than paying the conversion tax out of the funds you’re converting, look for other resources. After examining your present situation and long-term goals, your financial adviser can help you devise an approach that could involve one or more of these four options:
1. Tap a savings account or CD. Interest rates may be slowly rising, but returns on these accounts are still unlikely to match the long-term growth of a Roth. Just be careful that you are not dipping into funds that you already have set aside for other critical purposes, such as an emergency fund.
2. Sell stock. Yes, stock sales also are taxable events. But if your capital gains will be levied at a lower rate than the Roth conversion funds, the trade-off might make sense. Your financial adviser and tax professional can help you review this option and consider whether it makes sense for you to sell depreciated shares and use the losses to offset the taxes owed on conversion.
3. Ask beneficiaries to pay the tax. If you plan to pass a traditional IRA to children or grandchildren, they might be willing to help cover the Roth conversion costs. If they were to inherit a traditional IRA, they would be likely to owe income tax on the required minimum distributions. Explain to your beneficiaries that by helping pay the taxes owed on a conversion today, they effectively reduce their taxes in future, after they’ve inherited the Roth. This argument is especially persuasive if your beneficiaries are in a higher tax bracket than you are. They’d probably much rather inherit an account that’s not taxable.
4. Stagger the conversion. If no other sources of funding are available, you can spread out the levy by converting several small amounts over time. This staggered approach also can prevent a large IRA conversion from pushing you into a higher tax bracket. For example, someone who is at the upper end of the 33 percent tax bracket and converts a $100,000 IRA might find that income tips her over the threshold for the 35 percent tax bracket. Instead, converting $33,000 per year over three years might allow that same investor to continue paying taxes at her current rate. As always, discuss any tax and investment strategies you are considering with both your financial adviser and tax professional before you take action.
The taxes generated by a Roth conversion are a hurdle, not a barrier. Your financial adviser can help you find the means to cover the costs so you can potentially reap the benefits of these tax-advantaged accounts.
• Patrick S. O’Connor is the managing principal, senior financial adviser, PIM portfolio manager and a chartered retirement planning counselor at Wells Fargo Advisors Financial Network in Algonquin. He can be reached at 847-458-0142, firstname.lastname@example.org or www.algonquin.wfadv.com.