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Why Roth IRAs Are Still Red-Hot

What's the next big thing in financial planning?  It's actually something that has been around for years:  the Roth IRA.  This tax-advantaged account offers the promise of future benefits without some of the restrictions that hamper traditional IRAs.

What makes a Roth so special?  With a Roth IRA that's at least five years old, most distributions after you've reached age 59½ are completely tax-free, while earlier payouts may be wholly or partially tax-free under the tax law's "ordering rules" that treat the first money out of the account as coming from your contributions, which aren't taxable.  Also, you never have to take the "required minimum distributions" (RMDs) that force you to deplete a traditional IRA.  Those RMDs and other distributions are taxable at ordinary income rates (except for any portion representing nondeductible contributions) reaching up to 39.6%. RMDs for IRAs become mandatory after age 70 ½.

There are two main ways to establish a Roth and take advantage of its benefits:  through annual contributions or with a conversion from a traditional IRA. 

1.  Annual contributions.  You can set up a Roth IRA and make contributions each year of as much as $5,500 ($6,500 if you're age 50 or over).  But the ability to contribute to a Roth is phased at higher-income levels.

2.  Roth conversion.  Anyone can convert a traditional IRA to a Roth, or use a conversion to add to a Roth you've already established.  In either case, you must pay tax at ordinary income tax rates on the taxable portion of the converted funds.  Advance planning can help you minimize the tax damage.

One popular technique is to convert just enough to fill up extra "space" in the lower tax brackets while triggering as little tax as possible in the top tax brackets.  This can be particularly powerful if you expect to be in a higher tax bracket in retirement than you are in now.

Suppose you're married and file a joint tax return, you have $500,000 in a traditional IRA, and your adjusted gross income in 2014 is $130,000.  Using current tax rates, you are in the 25% tax bracket, but you anticipate being in the 35% bracket during retirement.  If you fill up the 25% tax bracket (which tops out at $148,850) by converting $18,850 in traditional IRA funds to a Roth, you'll save 10% in tax (the difference in the current 25% rate and the future 35% rate).  Assuming you repeat this strategy over several years, the savings could be as high as $50,000 (10% of $500,000). 

This assumes you can pay the conversion tax with funds from outside the IRA, which might be a problem.  Other factors also may come into play.  So be sure that converting to a Roth IRA in this way makes sense for your situation before you take the plunge.  Roth IRAs are hot, but you don't want to get burned.



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