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Living Longer, Living Better | Finance

Roth IRA conversion not for everybody

Conversion from traditional account has long-term advantages but initial tax hit can be a hurdle

Converting a standard individual retirement account to a Roth IRA is a great way to avoid an unexpected huge tax hit to your nest egg and create tax-free income for future use. Unless it isn’t.

A Roth IRA’s biggest draw is that it allows investors to reap investment gains tax free; that is, contributions are made with after-tax money, and any gains are not subsequently shared with Uncle Sam later. Investors are allowed to convert a traditional IRA into a Roth, so long as they pay taxes - at current rates - on the balance being converted. That upfront tax payment is the catch.

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Even if you are willing to absorb a big tax right away, financial advisers warn that it can take a minimum of five years of investment gains for a Roth to recoup the amounts lost to taxes. Moreover, it can take from 10 to 20 years for even the most well-invested Roth to yield significant gains, which is not ideal for boomers and investors in their 50s and 60s nearing retirement.

“I compare this to a Crock-Pot, because the longer you let something cook in there the better it’s going to be at the end of the day,’’ said Chris Hobart, president of Hobart Financial Group. “You can dip into it sooner, but it’s not going to be as good as it will be if you wait until 6 at night when it’s ready.’’

Roths have become a popular alternative - or adjunct - to the traditional IRA, which still remains the retirement savings vehicle of choice for most Americans. Roth assets increased to around $266 billion in 2011, up from $177 billion in 2008, thanks in part to more favorable regulations enacted by Congress.

Building a Roth IRA from scratch is not difficult, either. Investors can contribute a maximum of $5,000 into a Roth IRA each year, with those 50 and over allowed an additional “catch-up’’ contribution of up to $1,000.

So if you have maxed out contributions to your workplace retirement accounts but still want to sock money away, which should you choose? Generally speaking, Roths are great for investors who expect to be in the same or higher tax bracket when they retire; since most retirees probably expect to be in a lower tax bracket, the traditional IRA would seem to make sense.

Older investors are best served by using a Roth IRA to create a tax-free inheritance for their children or grandchildren.

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The big “but’’ is the US tax rate and where it is headed. With the federal government facing a substantial budget deficit, the Bush tax cuts due to expire and new health care laws calling for a broader tax base, the rate investors will pay in retirement could be could be substantially different than today.

As for conversions, the government allows investors to convert both their IRAs or 401(k)-type retirement plans into a Roth IRA at any time. But the switch does not make sense for everyone. Advisers suggest converting to a Roth as early as possible to both absorb the initial tax hit and to give those tax-free gains some time to build.

Investors closer to retirement age can still convert if their family has a history of longevity, but older investors are best served by using a Roth to create a tax-free inheritance for their children or grandchildren.

That upfront tax payment remains a significant hurdle for most people considering a conversion. A 2010 survey by USAA, a banking and investment firm for military families, found that more than one-third of IRA holders were advised not to convert by their tax counselors, and another one-quarter could not pay the taxes on the conversion.

Moreover, more than 40 percent of the surveyed USAA clients concluded a conversion didn’t make sense because they expect their tax rate would be lower in retirement.

Simply not knowing where you will be taxwise and incomewise in 10, or 20 years, may itself be an answer.

“I can say whatever I want and act as confident as I want, but the reality is I can’t tell you that this conversion is going to make sense in the future,’’ said Ken Kilday, a wealth manager with USAA.

Kilday said there is also a side effect of conversions that investors need to be aware of. The additional income you have to declare from the traditional IRA during the conversion may vault you into a higher tax bracket - for some high enough that you will have to pay taxes on your Medicare and Social Security benefits.

To avoid that, Paul Jacobs, a financial adviser with Palisades Hudson in Atlanta, suggested converting an IRA in pieces - small sums over several years. “For someone who has large itemized deductions, has a large IRA, and is typically in a lower tax bracket, converting the entire IRA whole hog in one year may not be appropriate,’’ added Jacobs.

One of the best uses of a Roth is for estate planning: Converting an IRA to a Roth and handing it down to a child or grandchild means your heirs will be able to access that money tax-free.

“If you’re at an age where you can go into a lower tax bracket and clean that money, that goes tax free for the rest of your life but is a phenomenal gift for your heirs - a tax-free inheritance,’’ Hobart said.

Roth IRAs also feature an escape hatch if, after the conversion, the account loses a lot of money because either the investor was too aggressive or the market had a rough period. Say a converted Roth of $100,000 craters and now has only $50,000, investors are allowed to “reconvert’’ the Roth back into a traditional IRA and recover the tax payments made during the initial switch.

There is, however, a limited window for reconversions: Oct. 15 of the year following the initial conversion. Financial advisers said reconversion can be common; Jacobs said several clients reconverted in October 2011 after shaky market performance flattened their earnings last summer. If investors are that risk averse, it may be best to avoid Roth IRAs altogether. “It’s not a one-size-fits-all opportunity and there are certain situations where a Roth conversion is not appropriate,’’ Jacobs said.

Jason Notte can be reached at notteham@gmail.com.
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