A growing number of Americans are moving money from their traditional individual retirement accounts into Roth IRAs.
At Fidelity Investments, for example, the number of people who converted IRAs into Roths has risen 7 percent in the first 11 months of the years, compared to the same period last year. That makes the second year in a row that conversions have increased.
“I expect that the Roth conversion will continue to grow as more and more investors become tax savvy,” said Ken Hevert, vice president of retirement products at Fidelity. “It’s a function of learning and education.”
Roths offer a variety of tax and planning advantages over traditional IRAs. Not only do they eliminate income taxes on most withdrawals, but they also get rid of required annual minimum distributions for Roth owners. That makes Roths incredibly useful to younger savers, folks looking for tax diversity in their retirement savings, retirees, and people planning to leave assets to their heirs.
Income restrictions still limit who can contribute directly to a Roth, but 2010 rule changes make it possible for people to now transfer funds from a traditional IRA into a Roth regardless of how much money they make, Hevert said.
Why aren’t there more conversions? Taxes are a major obstacle. In order to convert, you need to pay income tax on all earnings and pretax contributions that are moved from a traditional IRA into a Roth. Convert everything all at once, and you could end up with a very big tax bill. That’s why many advisers recommend a more gradual approach, doing a series of Roth conversions after carefully analyzing both the long-term and short-term impact on their income taxes.
“I like partial conversions,” says Christine Fahlund, senior financial planner with investment firm T. Rowe Price. “Do some and then do some and then do some again.” The result, she says, is a lot like dollar cost averaging, an investment technique in which people invest a set amount at regular intervals and thus protect themselves from market volatility.
The advantages of a Roth are similar for people who open and fund their Roths with contributions and for those who convert to a Roth from a traditional IRA or other retirement plan. But there are some important differences in the withdrawal rules.
Since Roths are funded with after-tax dollars, contributions can be withdrawn tax-free and penalty-free at any time — even before retirement. Withdrawals of earnings, however, generally are neither tax-free nor penalty-free until the owner both turns 59½ and has owned a Roth account for at least five years.
The rules for Roth conversions are stricter: If you are under 59½ you will pay a 10 percent penalty on any withdrawn Roth IRA conversion assets that have been converted for less than five years.
Earnings, again, are treated differently. Even if you’re already 59½, you need to have held any earnings on a converted amount for five years from the date of that conversion. Fail to meet those requirements and your withdrawal of earnings will get hit with taxes and a 10 percent penalty.
There’s also something called the “back-door strategy” used by high-income individuals who make too much to contribute directly to a Roth. Here people contribute after-tax dollars to a traditional IRA and then later convert that money to a Roth. This strategy works well for individuals who don’t have any preexisting IRA assets. Those with traditional IRAs will probably be required to pay tax on the conversion since the IRS won’t allow people to convert only their after-tax contributions.
So how do you decide whether to convert to a Roth? You need to calculate both your current and your anticipated future tax brackets, then determine the impact on your tax bills. You also need to consider your life expectancy, since newly converted Roth assets need time to grow to offset the initial tax bite. With no required minimum distributions, those who live long enough can spend down their taxable and tax-deferred assets first, thus allowing the tax-free assets in the Roth to keep growing.
Young savers are particularly good candidates for Roth conversions, says Fahlund. That’s because their current income is relatively low compared to what is likely to be in future years. Moreover, their Roth can benefit from “decades of compounding.”
Time is running out to do a Roth conversion this year, but you may want to convert if you’ve got the money to pay the additional tax and if your income this year is low, perhaps because of a job change or business loss.
If the tax picture looks more favorable in 2014, then waiting makes sense.
Remember, if you get it wrong — or if you find you don’t have the money to pay the taxes — you can undo it. You have until Oct. 15 to recharacterize all or some of your Roth conversion.
Only people under the modified adjusted gross income limits can make direct contributions to Roth IRAs.
The limits for 2013 are:
Married filing jointly: Less than $188,000
Single: Less than $127,000
The limits for 2014 are:
Married filing jointly: Less than $191,000
Single: Less than $129,000