Bloomberg: Roth IRA Change May Not Be ‘Game Changer’ for Wealthy Investors (emphasis added by Parsimony Research)
Changes to U.S. tax laws next year give high-income earners planning for retirement a decision to make: pay now or pay later.
Taxpayers making more than $100,000 a year in adjusted income will be allowed to convert to Roth IRA accounts from traditional IRAs after that limit is lifted at the end of the year. That means 16 million Americans, according to tax returns filed with the Internal Revenue Service in 2007, can consider whether they want to make tax-deductible contributions if they have a traditional IRA or pay the taxes up front and have tax- free withdrawals during retirement with a Roth IRA.
Which is better depends on future tax rates and how much the conversion will cost. It may not make sense to pay taxes today at a higher rate because many investors will be in a lower tax bracket during retirement, according to Tom Orecchio, a fee- only adviser at Modera Wealth Management in Old Tappan, New Jersey.
“From a tax perspective, I think when people do the math, it’s not going to be as game changing as they expect it to be,” Orecchio said.
Higher-income households that could benefit from the income limit changes are not rushing to switch, according to a survey released today by San Antonio-based United Services Automobile Association. The national survey of 1,259 adults between 45 and 64 years of age shows that for those with an IRA and a household income of $100,000 or more, 9 percent are planning to convert in 2010.
Tax Assumptions
Most IRA assets are held in traditional IRAs, based on a June report by the Investment Company Institute, a Washington- based trade group for mutual funds. Investors held $3.2 trillion, or 89 percent of IRA assets, in traditional IRAs at the end of 2008. Roth IRAs accounted for $165 billion, or 5 percent, of all IRA assets.
Converting to a Roth IRA for future tax-free withdrawals is based on the assumption that Congress won’t change the tax code, according to Linda Duessel, equity market strategist for Federated Investors Inc. in Pittsburgh.
“That’s a heroic assumption now more than ever,” because of increasing public debt and Social Security and Medicare payouts for baby boomers, Duessel said.
Opening a Roth IRA still has an adjusted income limit of $120,000 for individuals and $176,000 in 2009 for couples who file joint tax returns. Traditional IRAs don’t have income limits. The maximum annual contribution to Roth IRAs and traditional IRAs is $5,000 for savers under the age of 50 and $6,000 for savers over 50. The tax change doesn’t cap the amount that can be converted to a Roth IRA from a traditional IRA.
Holding Period
The Roth accounts, including those converted from traditional IRAs, must be held for five years and accountholders must be at least 59 and a half before money can be withdrawn tax free. Savers who don’t follow the withdrawal rules or meet exemptions face a 10 percent penalty for distributions, said Leonard Wright, a certified public accountant in San Diego.
Investors who decide to convert to Roth IRAs must declare the conversion amount on their tax forms. The tax owed depends on whether the assets being transferred are made up of pre or post-tax dollars, according to Ed Slott, an IRA consultant in Rockville Centre, New York. In 2010 only, converters will be able to pay the tax liability in 2011 and 2012.
“There are many people who simply don’t have that kind of a side account to pay the income tax, so for them it isn’t very practical to consider a Roth,” said Christine Fahlund, a senior financial planner at T. Rowe Price Group Inc. in Baltimore.
Tax-Free Withdrawals
Wealthy investors who won’t need to take money from an IRA in retirement might want to consider a Roth because unlike traditional IRAs, Roth IRAs don’t require withdrawals once accountholders reach 70 and a half, said Mitch Drossman, head of national wealth strategies for New York-based U.S. Trust, which is owned by Bank of America Corp. That makes Roth accounts a worthwhile estate planning tool as heirs can enjoy continued asset growth without paying taxes when they withdraw, Drossman said.
A partial conversion to a Roth IRA from a traditional IRA may be the most tax-efficient plan because of the diversification benefits, said Orecchio, who estimates about half of his clients may convert some money to a Roth IRA next year.
“You never know how the tax code will work in the future. By owning different IRAs, you’re protected from whatever the government might decide to do,” Orecchio said.
Partial Conversions
Partial conversions may be desirable for those with larger portfolios that would require a large tax payment at conversion, said Fahlund of T. Rowe Price. And the flexibility of partial conversions can also be beneficial to those who are self- employed or whose income varies year to year. In a year with less income, an investor can convert less of a traditional IRA to avoid having a larger tax burden for the year, according to Fahlund.
There’s a fallback for investors who decide to convert and regret the decision. A Roth can be switched back to a traditional IRA account, or recharacterized. Since investors who convert to a Roth IRA don’t have to pay taxes on the conversion until the following year, they have until April 2011, or October 2011, if they get an extension on their taxes, to reverse the conversion, said Slott, the IRA consultant.
“It’s like getting to bet on the horse after the race is over,” Slott said.
To contact the reporter on this story: Alexis Leondis in New York aleondis@bloomberg.net.
