What Makes the Roth IRA so Sexy and Who Should Fall in Love with It!

2010′s Great Roth Conversion isn’t just a neat, one-off tool for the rich, it can have repercussions for the hungry, up-and-coming entrepreneur as well.  Roth plans can be a boon long-term for those who believe that they will end up in a higher tax bracket in the future than the one that they are in now.  Since every entrepreneur is a dyed-in-the-wool optimist, if you’re not currently in the highest tax bracket, you probably plan on being so in the future!  So let’s review what makes the Roth so attractive and see who are the primary candidates who could benefit from a Roth conversion or a Roth plan.

Most of us make our retirement contributions the traditional, vanilla way: as tax-deferred contributions to a 401(k), IRA, or other retirement account.  Your rich Uncle Sam is giving you a bye on paying income taxes (but critically not payroll taxes) on the money you contribute in the current year so that he can get it back with interest when you start taking it out at retirement.  Our pal Roth, however, turns the tables.  You pay the taxes now in return for the ability to withdraw the earnings tax free upon reaching the age of 59 1/2 (if you have held the Roth at least 5 years).  You’ve already paid the tax on the money you have contributed, the principal, so you can usually withdraw that without paying any additional tax on it.  But why would you want to pay the taxes now?  After all, we’ve all heard of the time value of money, a dollar today is worth more than a dollar in the future.  Well, please allow me to make the case for the Roth.  I am compiling these with an emphasis on the advantages that are most likely to be attractive to the average Web Biz Finance reader, youngish, entrepreneurial types (should I add urbane and attractive as well, or would that be sucking up?)

The Advantages of the Roth

• It effectively enables you to increase the amount you contribute to the plan by front-loading the taxes.  The maximum annual contribution to an IRA (Roth or traditional) is currently $5,000.  Think about it, 5 grand that you will withdraw tax-free is always better than 5 grand you will have to pay taxes on, right?  The kicker is, it’s the rate that you will have when you take the money out that determines how much better.  Money Chimp has a cool calculator that explains this and allows you to, well, monkey around with the numbers.
• The ability to withdrawal contributions tax free prior to reaching retirement age gives you additional flexibility and, in theory at least, should allow you to be more aggressive in contributing.  Of course, if you don’t trust yourself with access to the money perhaps its better to have it less available.
• If you expect to be in a higher tax bracket in the future than you are now than the Roth plan can save you the difference in taxes.  Let’s say that you are a starving young professional in the 25% marginal tax bracket but you’re working hard, you’ve got a business on the side, and you expect to get into some big money before long.  Or, perhaps you think that tax rates are going to have to go up to pay for the TARP, the wars, and all the other expenses that our big spending Uncle Sam is racking up on credit.  Either way, you can lock in at your current tax rate and avoid any future uncertainty.
• You can both continue to make contributions after reaching age 70 1/2 (in a traditional IRA you cannot) and, even more important to most of us, you don’t have to make required minimum withdrawals at age 70 1/2.  The former is a nice tool for estate planning and the latter gives you both more flexibility and less paperwork.

The Disadvantage

The Rollover

Investors with traditional IRA’s and Adjusted Gross Incomes of less than $100,000 have long had the option of rolling over their traditional IRA into a Roth IRA.  Of course, to do so they have had then declare the entire value of their IRA as taxable income in the year of the rollover and pay the income taxes on it.  This can be quite a shock to your cashflow, as you can imagine.  2010 though, is special.  For 2010 only the income restriction has been lifted, letting the big money people in on the game, and the taxpayer is allowed to pay the tax over two years, numbing the tax blow a little and easing possible cash-flow issues.

Who Should Consider Rolling Over
An excellent article in the Journal of Accountancy does a great job summarizing if you could benefit from a rollover.  You could benefit if you:

• expect to be in a higher tax bracket when you retire
• want access to your IRA funds in 5 years or more but at less than 59 1/2 years of age.  Remember, one of the advantages of the Roth is that you can remove your contributions tax free at any time and only the earnings would be subject to penalties.  If you wanted to take your money out and use it for a non-traditional retirement, or to invest in a business, or to just plain squander it you could roll it over into a Roth, pay half the tax in 2011 and half in 2012, and then wait out the “seasoning period” (five years from the year of the rollover) and then withdrawal it without being subject to penalties.  This isn’t in the Journal of Accountancy but I could see this as being interesting to some readers.
• don’t plan on needing to use the money at age 70 1/2 and don’t want the hassle of minimum required distributions.
• are young and have a high income.
• Would like to pass money onto your heirs tax-free.

The Roth vs. traditional IRA question is an interesting one.  As with most strategies, one size does not fit all.  Below are some references for additional information.  Let me know it you’ve thought of something that I’ve missed!

The Wikipedia page on Roth IRAs.  It includes a pros and cons section.
Straight from the horse’s mouth.  The IRS gives the skinny on all the technical issues surrounding the Roth.
Investopedia defines the Roth but, more importantly, they provide links to multiple articles that give the who, what, why and where of the Roth.

Tweet This Post