One of the age old debates about investment retirement accounts is whether it is better to have your money in an account where you contribute pre-tax money (ie 401k plan or Traditional Roth) or in post-tax accounts such as a Roth IRA. Unfortunately there is no one right answer so this post will cover some of the factors of both types of accounts. Recent changes have made it possible for high income earners to convert their 401k and Traditional IRA accounts to a Roth IRA in 2010. For more information check out how to convert to a Roth IRA in 2010.
When Should You Do A Roth Conversion
- Conversion to Roth is advisable if you do not plan to make any withdrawals for a long time. For example, you are at the start of a new career and are 27 years old, you are gaining more than 30 years of tax-free earnings for paying upfront taxes now.
- Even if you have retired, you could still benefit from conversion if you do not plan to tap into the Roth for another 10-20 years. Further, with a Roth, you do not have to deal with meeting minimum distributions or dealing with penalties for failing to withdraw from a traditional IRA on turning 70 ½,.
- You plan to leave the money to your children or beneficiaries. Non-spousal beneficiaries who inherit an IRA have to pay taxes on the mandatory annual distributions; with a Roth, annual distributions are a must, but they are tax-free.
- You have non-deductible IRAs. In the run-up to the changes in tax law, many people contributed to a non-deductible IRA to make the conversion. That option is still open, and it is like a back-door form of conversion – if you are a high income earner, tyou can contribute to a non-deductible IRA and then convert it to a Roth each year. There is a limit of $5,000 for individuals under 50, and $6,000 for those above 50.
When Should You Not Do A Roth Conversion
- You cannot afford the upfront taxes. You must pay the taxes on your IRA on conversion. Do not use your IRA money to pay the tax bill as you will be hit with penalties and taxes on top of that – it like a double whammy. You can split the tax bill into two years, but watch out for proposed changes to tax rates, especially on the higher income brackets.
- You are a baby boomer on the brink of retirement. When you retire and make withdrawals from your IRA, you will more likely be paying a lower tax rate, say around 15%. You do not want to pay 33% taxes on your withdrawals while you are still working, to avoid having to pay them at a lower rate.
- You do not need the money and are leaving it to charity. The charity does not pay taxes, so conversion is pointless.
Consult your advisor or tax accountant if you have both pre-tax and post-tax contributions in your IRA and if your account is complicated by investment losses. There are easy ways to unravel the contributions.