August 2005

Congress’ Gift to Taxpayers – The Roth IRA

If you have heard about the Roth IRA, but you cannot quite believe it is one of the best tax law changes in our lifetimes, read on.

In his book The Retirement Savings Time Bomb. and How to Defuse It , Ed Slott ( America 's IRA Expert) said on pages 203-04 "The Roth IRA is the single best gift Congress has ever presented to the American taxpayer. It allows us to build retirement accounts that, over the long haul, will grow to incredible size - and remain free of income tax forever.Anyone eligible to start a Roth IRA.should do so. Now!" That might well apply to conversions, too.

Let's take a quick look at the advantages of converting to a Roth IRA.

Let's take a quick look at the disadvantages of converting to a Roth IRA.

That's basically it! Unless you are going to need to withdraw a substantial amount from your IRA within 5 years of conversion, the second disadvantage does not even apply. You can always withdraw the amount you have paid taxes on. The only real disadvantage is that you have to pay the tax when you convert.

WHO CAN CONVERT?

First of all, we need to make sure you know the rules on who can convert from a Traditional IRA to a Roth IRA. Basically, if you have income below $100,000 and you don't file as married filing separately, you can convert your IRA to a Roth IRA.

If your income is near the $100,000 level and you want to convert, look at the IRS instructions, or get professional help in calculation your Modified Adjusted Gross Income. The good news is that if you convert and later for some unforeseen reason have more income than is allowed to qualify for the conversion, you can "undo" the conversion. Sometimes the IRS actually has some good rules.

UNDERSTANDING THE TAX LIEN ON YOUR IRA

One of the keys to understanding the advantages of a Roth IRA requires you to understand that the IRS has a tax lien on your traditional IRA. Almost everyone understands that they have to pay tax on withdrawals from their IRA. What that represents is a tax obligation on the funds in your IRA. For example, if you have $100,000 in your IRA and you are in a 25% tax bracket, you owe $25,000 in tax on your IRA. Your "balance sheet" or "personal net worth statement" should look like this:

"But, my IRA grows free of tax if I leave the money in the IRA," you say. Well it actually grows on a tax-deferred basis. For example, if your IRA balance grows over time to $120,000, or 20% growth, your tax due also grows by 20%, or $5,000. Your IRA would then be worth $90,000 net, which is a 20% growth on the $75,000 net above.

The only way this relationship between the IRA Balance and the Net Worth changes is if the tax rate changes. If tax rates go up, the Net Worth goes down. If tax rates go down, the Net Worth goes up.

SOURCES OF MONEY TO PAY THE TAX ON CONVERTING YOUR TAXABLE IRA TO A ROTH IRA

Here is a list of possible sources to use to pay the taxes on Roth conversions. Most of these are obvious, but some might not be.