Sometimes when individuals start using ‘financial talk’, some of the rest of us get lost in the dust. Phrases like “401(k), 503(b), Traditional IRA, and Roth IRA” sound like another language. As a result, many people are overwhelmed by the many options, and so they choose a terrible alternative – to do nothing.
This is not a strategy I recommend. Instead, slowly wade through all the options and make an informed choice. When it comes to saving for retirement, any choice is better than doing nothing.
Today, I’m going to help walk you through the world of the Roth IRA and discuss whether it makes sense to convert to a Roth IRA.
What is an IRA?
IRA stands for Individual Retirement Account. IRAs represent an investment umbrella that offers certain tax advantages because this money is set aside for retirement. The government encourages retirement savings by offering tax breaks to those who save under a retirement umbrella like the IRA. Essentially, an IRA is a label or designation given to a portion of your investing dollars. An IRA is not an investment in itself, rather a designation for your investments.
As an example, you could own shares of Joe’s World Corn Crops in a non-IRA account, or you could own shares of Joe’s World Corn Crops in an IRA account. Within an IRA you can own all common investment offerings like a savings account, mutual fund, CDs, bonds, annuities, etc. The only difference is the one investment adheres to government requirements (the IRA), and it offers tax advantages.
However, to fully capitalize on the tax advantages, you must accept the rules and restrictions determined by the US government.
Key differences between the Roth IRA and the Traditional IRA:
When someone invests in a Traditional IRA, their investment amount is tax deferred. This means that if you make $50,000 in a year and contribute $5,000 to a Traditional IRA, you would pay income tax only on $45,000 ($50,000 – $5,000). However, when you withdraw your money from the Traditional IRA, you will pay taxes on that money. For this reason, it is called a tax deferred investment. Taxes are deferred to a later date (at the time the money is taken out).
If your $5,000 investment is now worth $10,000, when you take the money out you will pay taxes on $10,000.
A Roth IRA is not tax deferred. Instead, you pay your taxes up front when the money is put into the account. If you made $50,000 a year and contributed $5,000 to a Roth IRA, you would pay taxes on the full $50,000. So what’s the advantage? When you withdraw your money, you will not pay any more taxes. Thus, if your $5,000 investment is now worth $10,000, you will take out that $10,000 tax free because the taxes have already been paid, and your money grows tax free.
Here’s a simple analogy. The Roth IRA is like a fast-food restaurant where you pay when you first get your food, but you don’t pay anything when you walk out. The Traditional IRA is like a sit down restaurant where you don’t pay anything when you come in and eat, but you’ll pay on your way out the door.
Because your investments grow tax free, the Roth may be more advantageous for some investors.
Investors always have the opportunity to roll a Traditional IRA into a Roth IRA, and whoever did that in 2010 enjoyed some special advantages. Why?
- Typically there is an income cap on who is eligible to convert a Traditional IRA to a Roth IRA. If you earn more than $100,000, you were previously not allowed to convert to a Roth IRA. However, in 2010, anyone can convert their Traditional to a Roth regardless of income. This, of course, was good news for high wage earners.
- When you convert a Traditional IRA to a Roth, you’ll pay taxes on that money. Remember, with the Roth IRA, you always pay taxes up front, not at the back end. As such, you can expect a higher tax bill the year you convert. If someone converted to a Roth in 2009, those taxes would have been due in 2010. However, if someone converted in 2010, the taxes due will be spread over a two year period (50% in 2011 and 50% in 2012).
Important Considerations Before Converting to a Roth IRA
The older you are, the less a conversion makes sense. When you do a conversion you cannot withdraw any earnings on that money for five years. You can still access the actual contributions immediately, but not the earnings. Since you won’t have as much time for your income to grow tax free, your age might make a conversion less appealing.
Carefully consider your tax bracket. If your conversion will push you into a higher tax bracket you might instead consider converting a portion each year to avoid paying higher taxes. You can convert over several years instead of just in one year.
If you will have a child who will be applying for financial aid, you need to be aware of the fact that the Roth IRA conversion amount will be considered as income on your financial aid form.
Do you have the money to pay the taxes? If you cannot pay the taxes (from outside funds) then the conversion makes less sense. By converting and using other funds for the taxes you indirectly get to invest more money.
What do you think will happen to tax rates in the future? Of course, no one knows, but if taxes go up in the future, you’ll be glad if you have a Roth. However, if they go down then the advantage might tilt towards the Traditional IRA.
Before converting, you’ll want to be sure you properly understand the implications of your decision. While it can be reversed, it is more efficient if you make the right decision the first time. Kiplinger has a quiz to help you test your knowledge regarding Roth conversion rules.
After properly evaluating all the information, you should be able to make an informed decision to know if converting to a Roth IRA is a right choice for you.