Introduction
There are a myriad of retirement accounts to choose from these days. Under the Internal Revenue Code, taxpayers and eventual retirees face an alphabet soup of retirement plans to choose from.
Among the more popular retirement plans is the Individual Retirement Account (IRA), which an individual can set up at a bank, an investment firm, or even an online account. People can create and fund these accounts entirely on their own at little or no cost to them. This is in contrast to employer sponsored retirement plans such as the 401(K), SEP, SIMPLE, and defined benefit plans, which an employer would have to undertake and fund in tandem with an employee. There are two kinds of IRAs, traditional IRAs (which offer a tax deduction when funded) and Roth IRAs (which do not offer the upfront tax deduction, but distributions are taken free of tax). The scope of this article focuses on the IRA and whether converting a traditional IRA to a Roth IRA is a good idea.
Background
Traditional IRA contributions, as stated above are deductible from taxable income in 2011 up to $5000. The traditional IRA grows tax deferred until the money is distributed to the holder of the account, at which time the distributions are taxed at the ordinary income rate of the individual receiving the distribution. Roth IRA contributions are not deductible from taxable income, but the Roth IRA appreciates tax free until the time of distribution. When the proceeds are distributed, the amounts are tax free to the account holder. Considering the Roth IRA potentially has 30 to 40 years of appreciation for a young couple, the Roth carries some huge potential tax benefits.
This dichotomy of IRAs leaves individuals to face a perplexing question regarding which IRA is better. On one hand, the individual gets a current tax savings, which is favorable from the vantage point of a current cash position. Looking at the Roth IRA, the individual gets tax free income at a time when the individual’s income tax bracket may be elevated as opposed to earlier in life and their career when their tax bracket is generally lower.
Considerations
As stated above, the traditional IRA has the advantage of tax deductible contributions while facing the detriment of income taxes upon distribution. The Roth IRA has the opposite effect with contributions being nondeductible and the distributions being nontaxable. Generally speaking, the Roth wins from the point of income tax savings. Both IRA annual contributions are limited to $5000 this year and next. The difference is that the Roth holder might pay $1000 more in taxes in the year of contribution than the traditional IRA account holder who receives a deduction. The traditional IRA account holder, on the other hand, has the detriment of paying taxes on the IRA distribution after it has had 30 years to appreciate.
The Roth IRA is also superior from an inheritance standpoint as well. Generally, traditional IRAs are treated as ordinary income. to beneficiaries. Paying tax at a regular income tax rate on an inheritance is a high tax to pay. Roth IRAs on the other hand, are not taxable to the recipient. Just as they would not have been taxable to the owner of the Roth IRA, it is not taxable to the heir as well. The advantage for tax free inheritance goes to the Roth IRA.
The traditional IRA carries penalties when early distributions are taken. The Roth IRA provides limited exceptions in which distributions can be taken without penalty. The big difference in flexibility is that a Roth IRA has already been taxed. When principal only amounts are taken early from a Roth IRA, the principal is not added to the taxable income of the taxpayer (unlike the traditional IRA early distribution which would be taxable in full). The Roth IRA is good as far as flexibility is concerned.
Conclusion
After having read this, do you regret not converting your traditional IRA to a Roth IRA? Do you think that opportunity has passed because it is no longer 2010? If you regret not converting your traditional IRA to a Roth, you have until October 18, 2011 to make the election to convert.
In short, Roth IRAs are generally better than traditional IRAs for most people. While the merit of the traditional IRA cannot be forsaken, generally Roth IRA accounts are better for the younger person. While the Roth IRA carries better income tax, inheritance, and flexibility points, the traditional IRA cannot be written off entirely. The traditional IRA is still a good retirement investment vehicle superior to that of general savings accounts, non-tax protected investment accounts, and savings bonds. Both Roth and traditional IRAs offer good tax savings up front and are, to a degree, resistant to bankruptcy proceeding. Overall, the Roth IRA wins, but the traditional IRA still has merit for many. If you have questions, please contact The Center.
By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors