To Convert or Not To Convert: Roth IRAs
A while back, we had mentioned that we were reassessing our investments and had discovered some... [ahem] irregularities. We're getting that taken care of as well as getting our Baby steps back in line - retirement savings first, then college funding (note the updated disclosures).
While doing so, our investing adviser (one of Dave's ELPs) suggested that we convert our traditional IRAs to Roth IRAs. This was something that I hadn't previously considered, but then I guess that's why you have investment advisers. Before meeting back with him, I did some research and found some surprising things.
First, for those that don't know - Traditional IRA vs. Roth IRA - what's the difference? Both are considered 'tax-advantaged' retirement arangements. Both allow you to control the investments. But there are some important differences.
Traditional IRAs are funded by pre-tax contributions, meaning the money gets pull from your paycheck before Uncle Sam gets his cut. This is good in the sense that your investing isn't hampered by the government's greed. But at some point you'll have to pay taxes on that money if your are going to take it home. That point is retirement. When you take distribution, you will be taxed on the contributions AND the growth.
Roth IRAs are funded by after-tax dollars, meaning the money can only be deposited after you've paid taxes on it. This is bad in the sense that you'll likely have ~25% less to invest with. But this is awesome in the sense that you've already paid your taxes, and when you retire, all that growth is tax-free. That's kind of a big deal.
So it's fairly obvious why you would want to convert a traditional IRA to a Roth IRA - tax-free growth. We're money ahead if we never add another dime to it. But not so fast, to get there, there's some bumps in the road to get there.
Do you have a Traditional IRA? Have you considered converting it to a Roth?
While doing so, our investing adviser (one of Dave's ELPs) suggested that we convert our traditional IRAs to Roth IRAs. This was something that I hadn't previously considered, but then I guess that's why you have investment advisers. Before meeting back with him, I did some research and found some surprising things.
First, for those that don't know - Traditional IRA vs. Roth IRA - what's the difference? Both are considered 'tax-advantaged' retirement arangements. Both allow you to control the investments. But there are some important differences.
Traditional IRAs are funded by pre-tax contributions, meaning the money gets pull from your paycheck before Uncle Sam gets his cut. This is good in the sense that your investing isn't hampered by the government's greed. But at some point you'll have to pay taxes on that money if your are going to take it home. That point is retirement. When you take distribution, you will be taxed on the contributions AND the growth.
Roth IRAs are funded by after-tax dollars, meaning the money can only be deposited after you've paid taxes on it. This is bad in the sense that you'll likely have ~25% less to invest with. But this is awesome in the sense that you've already paid your taxes, and when you retire, all that growth is tax-free. That's kind of a big deal.
So it's fairly obvious why you would want to convert a traditional IRA to a Roth IRA - tax-free growth. We're money ahead if we never add another dime to it. But not so fast, to get there, there's some bumps in the road to get there.
- First and foremost, converting from a Traditional IRA to a Roth, as far as the government is concerned, means that you are bringing the money home. Thus, taxes ar due.
- There is two options to pay those taxes - with funds from the investment or with money from outside the investment. The concensus seems to be that if you can't pay the taxes from outside the investment, then you shouldn't do the conversion.
- To help with the taxes a bit, in 2010 you can spread that tax burden across 2010, 2011, and 2012. Not only does that spread out the tax payment, but also the income. That can help you from jumping to the next tax bracket if you were close before.
Do you have a Traditional IRA? Have you considered converting it to a Roth?
3 comments:
Actually, that's not the whole picture. The math is actually the same, if taxes stay the same:
http://www.dogatemyfinances.com/2008/07/why-i-heart-roth.html
The problem is, your taxes won't be the same. You're comparing an effective rate (the future) with a marginal rate (today). Since you always pay less taxes on less income, it's possible that in retirement you pay less. In fact, it's likely unless you are in 500K ish income range. So, Roth isn't as great as it sounds.
I've heard that Dave Ramsey recommends doing the conversion when you can pay cash for the taxes that's generated.
Now there’s a talk going on about people converting their IRAs into Roth Individual Retirement Account. Roth Ira is the best for the people who are on the right side of age, because the Roth IRA allows for tax waiver. You can always compare between the pros and cons of a Roth IRA account and a normal IRA account and then decide upon it.
Post a Comment