By Mark Miller
CHICAGO Jan 21 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
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withdrawn at any time, but penalty-free withdrawal of earnings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
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
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
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
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