Rachel Haig: I'm Rachel Haig for Morningstar.com. A new tax provision has created new opportunities for Roth IRA conversions in 2010. Here with me to discuss this is Morningstar's director of personal finance, Christine Benz. Thanks for joining me, Christine.
Christine Benz: Hi Rachel, nice to be here.
Haig: So, what's the special opportunity in 2010?
Benz: Well, right now, in 2009, you have to have income of less than $100,000 to be able to convert your traditional IRA assets to Roth. Beginning in 2010, though, anyone of any income level will be able to make the conversion. And the other great thing about converting in 2010 is that you'll be able to split the tax hit associated with that conversion over 2011 and 2012. So that will help ease the pain a little bit.
Haig: What's the big benefit of converting to a Roth IRA and who does it make sense for?
Benz: A couple of key benefits. First is that you will be able to take tax-free withdrawals in retirement. So that's a huge advantage.
And the other big benefit is that you don't have to take distributions in retirement, unlike with traditional IRA assets.
So, the types of individuals for whom this would make sense would be first of all the person who has many years until retirement, so they have time to recoup the tax hit associated with the conversion.
Also people who are in higher income tax brackets and have not been able to contribute to Roth IRAs, because they earn too much, but maybe they have a lot sitting on the sidelines in traditional 401(k)s or other retirement vehicles that will be taxed upon retirement. That will be a person for whom a conversion could make sense, because they can get at least part of their retirement assets into that tax-free withdrawal category.
And finally, the Roth conversion can make sense for people who have a lot of retirement assets, have a lot of assets period, perhaps, and don't expect to need to take distributions from their IRAs in retirement. They can stretch out the tax benefits for their heirs and leave those IRA assets to their heirs. And the Roth, because it doesn't require distributions, allows them to do that.
Haig: Converting to a Roth IRA and paying taxes now is basically a bet that taxes will be higher later, so you want to get them out of the way now. What about the possibility, though, that someone's income might be much lower in the future when they're retiring?
Benz: You're absolutely right. You're betting on a lot of variables about which we really have no idea. I think you can look at issues like the federal deficit and so forth and maybe safely assume that taxes could be higher in the future, but we don't know. But the reason I like an IRA conversion as an idea for a lot of different types of investors is that it helps you buy some diversification of tax treatment for yourself.
So just as you want asset class diversification in your portfolio, it can also make sense to think about having some assets that will be taxed upon withdrawal in retirement and have some that you'll be able to withdraw on a tax-free basis.
Haig: Speaking of that possibility of higher taxes in the future, there's been some conspiracy-type discussion that what if the government takes away the tax benefits of the Roth IRA and you have to pay taxes again in the future? Do you have any thoughts on that?
Benz: Well, people are perhaps legitimately worried about that, because we really don't know what the tax code will look like in the future. One thing I take some consolation in is that the Roth, heretofore, has been pretty much a middle-class savings vehicle. Now some higher income savers will be able to get in on the act.
But you think about the unpopularity of raising the tax on people who have been saving for retirement and they're mainly middle class people. So I think that there could be sort of a political headwind to changing the tax treatment of Roth assets.
And the other thing is that if you were to be taxed upon withdrawal, you wouldn't be taxed again on the money that you've already paid taxes on, you'd just be taxed on your investment earnings. So it wouldn't be the whole kitty. It still wouldn't be good, but it wouldn't be maybe as bad as being taxed on that whole pool of assets.
Haig: Are there any people who you think would be better off staying in their traditional IRA or their traditional 401(k) rather than converting to a Roth?
Benz: It's a great question, Rachel, and it's also a good time to point out that it really pays to check in with a tax advisor or financial advisor before you decide to make a conversion. But the key category of individuals who should think twice about converting would be people who don't have the money on hand to pay the taxes associated with the conversion and they're under the age of 59 and a half.
So for people like that who are going to have to withdraw IRA assets to pay the taxes, they'll owe taxes upon that withdrawal as well as an early distribution penalty. So that would be a big red flag, a big reason to think twice about doing it.
And the other key type of individual would be someone who is close to retirement and hasn't amassed a lot in terms of retirement assets. For that person, they're probably better off assuming that they will be in a lower tax bracket upon retirement and taking those taxed distributions in retirement rather than switching to Roth status.
Haig: All right. Well, thanks for those insights.
Benz: Thanks, Rachel.
Haig: For Morningstar.com, I'm Rachel Haig.