By Nancy A. Hartsock
Financial Advisor and Financial Planning Specialist
The Hasenberg Hartsock Group at MorganStanley SmithBarney
Be Inkandescent Magazine • May 2010
You may have read that tax law changes went into effect in January that made everyone eligible for a Roth IRA conversion, regardless of income level or tax filing status.
What’s so special about a Roth IRA?
The assets you are working hard to build now will become tax-free income in retirement. Rather than paying taxes when you withdraw the funds in retirement, you pay taxes on the assets when you invest in a Roth IRA.
If you have a Traditional IRA or an employer-sponsored retirement plan, you may be wondering if you should convert those savings to a Roth IRA. There is no one definitive answer to that question, but following are a number of reasons why, depending on your personal financial situation, converting an existing retirement plan to a Roth IRA could help you meet your financial goals.
You don’t expect to need all of the funds when you retire
With a Traditional IRA, you must stop contributing and start taking minimum distributions from your account at age 70½. Roth IRAs have no such age restrictions: there’s no contribution cutoff, provided income requirements are met, and no rule that you must begin tapping your account at age 70½. Your funds have the potential to grow tax-deferred as long as you want and you gain greater control over your income in retirement. You can tailor withdrawal amounts to your actual income needs—or eliminate them altogether in any given year
So if you are past age 70½ and would like to quit taking those required minimum distributions, you may still have the option to convert some or all of your IRA into a Roth, allowing those funds to have the potential to grow tax-free for your own needs later in life or for your heirs.
Note that you will need to pay taxes on the taxable amount of the IRA at the time of the conversion, so you should review this option carefully with your tax advisor before electing to convert to a Roth IRA. Also, the funds may only be converted after any current year required minimum distributions have been withdrawn.
You want to leave a lasting financial legacy to your heirs
If you won’t need your IRA to fund your retirement income, a Roth IRA can be an effective wealth planning tool, since heirs can enjoy continued asset growth potential without paying taxes when they withdraw assets.
By using a “stretch IRA” strategy, you can extend the tax-deferred growth potential and tax-free income benefits of your Roth IRA across multiple generations. This works by taking advantage of the fact that, while the beneficiaries of your Roth IRA (other than your spouse) will be required to take minimum distributions annually after your death, those distribution amounts will be calculated using a life-expectancy factor based on their own age, not your age.
This allows more of the funds to remain in the account longer, continually reaping the benefits of tax-deferred growth potential, and if your beneficiary outlives the account, it can similarly be passed on to the next generation, and so on.
You’re concerned about taxes
You’re aware that diversifying your portfolio by investing in multiple asset classes, including stocks, bonds and cash, can be a way to mitigate risk. The same logic applies to tax diversification: by spreading your retirement assets across different types of accounts provides diversification.
A tax-free Roth account combined with a taxable account, like a brokerage account or mutual funds account, and a tax-deferred account, like a 401(k) or Traditional IRA, can give you the flexibility to potentially keep taxes low in retirement. This is especially important if you’re concerned about future tax increases or you think that your tax liabilities may be higher in retirement.
Converting some of your Traditional IRA to a Roth IRA can be an effective strategy that allows you to take income from different sources to potentially keep taxes low in retirement.
You think that you might need some of the money before you retire
If you withdraw funds from a Traditional IRA before age 59½, not only will you be taxed on the value of the funds withdrawn, you will also be subject to a 10% early-withdrawal penalty unless an exception applies.
With a Roth IRA, you can withdraw the original contribution at any time, without penalty. You can even withdraw earnings, but if you do not meet the requirements listed above regarding the length of time held, age and other considerations, you will be taxed on the earnings when you withdraw the funds.
Is a Roth right for you?
We have touched on some key benefits of converting to a Roth IRA, but for many individuals a Roth conversion may not be the best strategy. If one or more of the following apply to you, it might be best for you to avoid conversion or to only convert a portion of your retirement account:
- You expect that your tax bracket will be the same, or lower, in retirement.
- You do not have funds available to pay the extra taxes from the conversion.
- You only have a short time frame to take advantage of tax-free compounding before retiring.
- You have projected income needs equal to or greater than the required minimum distributions of the IRA.
Get Help Making your Decision
To help you understand how a Roth conversion will likely impact your financial scenario, ask a Morgan Stanley Smith Barney Financial Advisor to provide a personal Roth Conversion Illustration Report for you.
This report explores your specific situation, factoring in such variables as the amount to be converted, the distribution year, your date of birth and where you are in the retirement planning cycle.
Based on this input, the report shows the after-tax future value of an IRA balance, comparing the outcomes of a Traditional IRA with those of a Roth IRA. You’ll also be able to see the wealth planning advantages of “stretching” a Roth IRA over multiple generations.
Finally, as with all tax related issues, you should also discuss your situation with your tax advisor.
About Nancy Hartsock
Nancy is a financial advisor and financial planning specialist with The Hasenberg Hartsock Group at MorganStanley SmithBarney in Washington, D.C. She specializes in wealth management, financial planning and multigenerational family work, helping clients reach their wealth goals through hard work and a common-sense approach to successful investing.
Prior to her career as a financial advisor, Nancy worked for 25 years in the health-care industry, with the last 10 years in senior management as a business owner.
About MorganStanley Smith Barney LLC
Morgan Stanley Smith Barney LLC and its affiliates do not provide tax or legal advice. To the extent that this material or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
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