COLUMN-Why more Americans are putting their eggs in Roth baskets
By Mark Miller
CHICAGO Jan 21 (Reuters) - Affluent Americans are showing a growing preference for paying taxes on their retirement savings sooner rather than later.
Data released earlier this month by the Internal Revenue Service shows that conversions from tax-deferred individual retirement accounts to Roth IRAs increased ninefold in 2010, to $64.8 billion. That was the first year when a $100,000 income limit on eligibility to convert was eliminated - and it marked the first time the amount of assets converted to Roths exceeded contributions.
For wealthier households, conversions are more relevant than direct contributions to a Roth IRA. This year the full direct contribution is available to single filers with income up to $114,000, and $181,000 for joint filers. Annual direct contributions to IRAs (Roth and traditional) are limited to $5,500 annually (plus $1,000 in catch-up contributions if you're over age 50).
But there's no limit on conversions for investors with multiple IRAs, or on the amount that can be converted.
Fidelity Investments saw a fivefold increase in Roth IRA conversions in 2010, and "steady growth since then," says Lauren Brouhard, senior vice president for retirement. "There definitely are benefits for wealthier households," she says.
Paying taxes now rather than later isn't beneficial if you expect to be in a lower tax bracket when you begin drawing down funds in retirement - which is the case for many retirees. But Roth IRAs offer several other advantages over traditional IRAs.
With a traditional IRA, you can begin withdrawing funds at age 59 1/2 without penalty, and distributions are taxed as ordinary income. Roth contributions are made with post-tax dollars; the contributions and investment returns are free from federal taxes - and usually from state and local taxes - when you withdraw them, so long as the assets have been held in the Roth for at least five years. (Roth contributions can be withdrawn at any time, but penalty-free withdrawal of earnings must wait until age 59 1/2.)
With a Roth conversion, you pay income taxes in the year funds move out of the traditional IRA. Unlike a traditional IRA, Roths generally are not subject to required minimum distributions after you turn 70 1/2. That's a terrific feature that can help you control your tax burden in retirement and even pass along assets to your heirs tax-free (though heirs would still be subject to RMDs).
"It's really a pay-now or pay-later decision," says Brouhard. "Increasingly, investors understand that it's easier to predict today's tax impact on withdrawals than tomorrow's - and people are seeking control. A Roth gives you more control - when to pay taxes, when to take distributions and who takes distributions."
Lifting the $100,000 income limit on eligibility for conversions opened the floodgates for affluent and wealthy retirement savers to move to Roths. The IRS data shows that 57 percent of all households that made conversions in 2010 reported income over $100,000. And the converters tended to be young: 65 percent were under age 60, and 41 percent were under 50, the IRS report shows.
It's likely that most of these younger households had sufficient resources outside their IRAs to pay the income tax bills generated by conversion, since using funds in the IRA would have generated a 10 percent penalty for early withdrawal.
Roths also are getting more attention inside 401(k) plans, although growth is much slower than it is for IRAs.
Congress widened the opportunity to convert 401(k) assets to in-plan Roths as part of the 2012 "fiscal cliff" deal. The idea was to raise near-term tax revenue by making it possible for all retirement savers to convert their 401(k) accounts to Roth 401(k)s.
The American Taxpayer Relief Act of 2012 permitted all retirement savers to convert existing 401(k) retirement plan assets to a Roth 401(k), so long as their plan offered Roth options and added the conversion feature. Previously, conversions could be done only by savers who also were eligible to take a distribution from the plan - in most cases, people 59 1/2 or older.
Fidelity says 42 percent of plans it administers offer a Roth savings option, up from 21 percent in 2009 - but just 6.6 percent of employees use the Roth option, Brouhard says. Of the plans that offer a Roth option, 16 percent offer in-plan conversions, she says.
"It's still a relatively new feature," Brouhard says.
But workplace Roth conversions also have a couple drawbacks compared with Roth IRAs.
Roth IRAs feature a nifty "take-back" feature that allows you to undo conversions that don't work out. If you convert IRA assets that subsequently fall in value, you still owe taxes on the amount of the original conversion. "Recharacterization" allows you to reverse the conversion and send the assets back to your traditional IRA. Roth 401(k) conversions don't have this feature.
And unlike a Roth IRA, Roth 401(k) accounts are subject to the standard RMD requirements, though you can get around this by rolling over your account to a Roth IRA before you hit age 70.
Nevertheless, Roth IRA and 401(k) conversions are likely to see strong growth as more retirement savers recognize the benefits of tax diversification for the drawdown phase.
A Roth can be an effective hedge against future income tax rate hikes, and it can help you manage your tax burden year by year. You could, for example, take withdrawals from a traditional IRA up to the top of a tax bracket, and then take any money you need above that from a Roth IRA.
"All investors should at least consider a Roth," Brouhard says. "Converting at least part of a traditional IRA or 401(k) gives you much more flexibility when you reach the distribution phase."