Are Roth Accounts Right for Me?

By: Jonathan D. Pond | Source: AARP.org | August 24, 2009

I'm thinking about converting my 401(k) to a Roth IRA. What is your opinion? –Steve, Indiana  

Roth IRA conversions were the rage when they were first introduced in 1998, but since then, they have fallen off the radar screen. That's too bad, because many people who stand to benefit from Roth conversions fail to take advantage of them. True, they cost money, but they are often worth the outlay. Why? Some explanations are in order.

Most working people know that they can make annual contributions to Roth IRA accounts. But they may be less familiar with the tax rules that permit those who qualify to convert their traditional IRAs and workplace-retirement plans into Roth IRAs. The downside of a Roth conversion is that you'll have to pay taxes on everything you convert, except for the original value of any nondeductible IRA contributions you made along the way. But that's not such bad news, since you know that later, you'll be able to withdraw the Roth money totally free of federal income taxes.

Originally, the rules allowed only traditional IRAs to be converted into Roth IRAs. But now you can convert 401(k)s and many other retirement-savings plans directly into Roth accounts, although plan participants who are still working generally have to wait until they change jobs or retire to be able to do the conversion from their 401(k) or other plans. (Some plans permit workers age 59½ or older to roll their 401(k)s over into traditional or Roth IRAs while still remaining enrolled in the plans.)

Even those who have been retired for several years stand to reap substantial benefits from Roth IRA conversions.

Should You Consider a Roth IRA Conversion?
While everyone's situation is different, the following guidelines will help you make the right decision on a Roth IRA conversion, if you qualify under the 2009 income limits. However, don't be discouraged if you don't qualify for a Roth conversion in 2009 because your income is too high. Hope is on the horizon.

The younger you are when you convert to a Roth IRA (as well as make annual contributions to a Roth), the better. But it's probably never too late to consider a conversion. Here are three important matters to consider:

1. How long will it be before you expect to make withdrawals from a Roth? A Roth conversion will probably work to your advantage if you don't need to tap into the money for at least 10 years. But the longer you wait, the more tax-deferred, tax-free growth you'll realize. This means that even retirees may benefit from Roth conversions. The reason? When you retire, you won't need to use a sizeable portion of the money you have in traditional IRAs or other retirement plans for at least 10 years. After all, you're planning for a much longer retirement. By converting your retirement-plan money to a Roth IRA now, you'll have more income available for spending in your later retirement years. Another benefit is that no federal income taxes will be due when you make Roth IRA withdrawals.

2. Do you expect to be in the same or higher tax bracket when you're retired? If so, the Roth would be beneficial. If you expect to be in a lower tax bracket (most retirees won't), then a Roth conversion (or Roth contribution, for that matter) may not be worthwhile.

3. Can you afford to pay the taxes due from the Roth conversion out of money that is outside your retirement accounts? It doesn't make sense to take money out of retirement accounts (which will be subject to taxes and, perhaps, penalties) to pay the taxes due from a Roth conversion. You'll need to have enough non-retirement-account money to be able to pay the taxes.

All in all, you have a lot to gain by considering a Roth IRA conversion, but you need to do some homework first. If you have a tax adviser, make an appointment. Most financial-services firms, including banks, brokerage firms, and mutual fund companies, offer worksheets and software on their Web sites.

By using your adviser's resources, you can figure out how much you stand to benefit from a Roth IRA conversion. If you take advantage of Roth IRA conversions early in your life, you will gain time to allow the Roth IRA to work its magic. Don't forget, Roth IRA conversions can work for people in their 60s and 70s, too.

4. Roth conversions for all, beginning 2010. If you earn too much money to qualify for a Roth IRA conversion, be patient. Starting in 2010, Roth conversions can be made without any income limitations. Even Bill Gates will qualify! This could give you an opportunity that's simply too good to pass up.  

My employer is introducing a Roth 401(k) plan. Should I make contributions to it or to my regular 401(k)? –Jon, Massachusetts

Because our elected officials in Washington are always looking for ways to encourage workers to save more for their retirements, a new generation of 401(k) and 403(b) plans—the Roth 401(k) and Roth 403(b)—were introduced in 2006.

While employers have been slow to offer them, you may become eligible at some point. Then you'll need to decide whether to stick with the old 401(k) or 403(b) or to switch to a new model.

Here are the differences between the two:

	Traditional 401(k)/403(b)	Roth 401(k)/403(b)
Contributions	Pre-tax	After-tax
Withdrawals	Taxable	Tax-free

 
The crux of the decision is whether to take the tax break now in the form of, in effect, a tax deduction for your contribution, or to forego today's tax break in exchange for being able to withdraw the money free of federal income taxes when you're retired.

Here are some crucial questions to address before deciding to switch all or a portion of your contributions from a conventional 401(k) or 403(b) to a Roth 401(k) or Roth 403(b):

 

• Do you expect to be in a lower tax bracket when you retire? The prevailing wisdom is to take the tax break now with a traditional 401(k) or 403(b) if you expect to be in a lower tax bracket when you retire. But before dismissing the Roth alternative on that basis, take heed that you may not be in a lower tax bracket when you retire. Even if you are, unless it's dramatically lower, the tax benefits and security of enjoying tax-free income during retirement may outweigh the benefit of taking the tax break now.
• Do you need the immediate tax break from a traditional 401(k) or 403(b) in order to be able to afford to make the contribution? If you need the tax break now in order to make your planned contribution, you should probably stick with the traditional alternative. But here's a homework assignment: Plan now to get into a position where you can make a similarly generous contribution to a Roth next year.
• Will you be able to wait at least 5 years and until you're at least age 59 ½ before making withdrawals from a Roth 401(k) or 403(b)? I hope the answer to this is in the affirmative, because that's the time you need to wait to beat Uncle Sam out of any taxes or penalties from your Roth 401(k) or Roth 403(b).

Additional Considerations

Here are some points to weigh when thinking about contributing to a Roth 401(k) or 403(b):

• Much larger contribution limits than Roth IRA. If you like the Roth IRA, you'll adore the Roth 401(k) or 403(b), because the annual contribution limits are much higher than the $5,000 annual Roth IRA contribution limit ($6,000 if you're age 50 or better).
• No income limits. Has your income been too high to qualify for a Roth IRA? There's good news. There are no income limits for making contributions to Roth 401(k) or 403(b) plans.
• Employer match doesn't qualify. But all of the news isn't good. You can't put any employer's matching contributions into the Roth. The employer can still put its match in a traditional 401(k), so you don't lose it, but later withdrawals from that account will be taxable.
• Roll over to a Roth when you leave your job. You can roll your Roth 401(k) or 403(b) account into a Roth IRA when you change jobs or when you retire.
• Favorable distribution rules. In addition to the primary allure of a Roth—the ability to withdraw money tax free, as opposed to paying taxes on withdrawals from a traditional 401(k)—you won't have to make minimum distributions beginning at age 70 ½. That means the tax-deferral and estate planning advantages of the Roth can be enormous.

Finally, if your employer doesn't offer a Roth 401(k) or 403(b), ask if this is something they would consider. These plans can make a big difference in your retirement prosperity.