The author is a Norristown, PA tax and estate-planning specialist, and an editorial consultant to this magazine.
Starting Jan. 1, 2010, you will have a new opportunity to accumulate wealth in a tax-free piggy bank.
Roth IRAs are composed of after-tax money. This means that when you convert your traditional IRA into a Roth IRA, you will pay tax on a portion or the entire converted amount. To make a Roth IRA tax-free, the account has to be open for five tax-years and withdrawals must be made after attaining age 59-1/2. This five-year rule is based upon the timing of when you start the account, not upon when each dollar is contributed. Therefore, it makes great sense to convert at least some money by age 54 1/2 so that the five years have elapsed by the time you attain age 59-1/2. If you later convert additional money, the five-year clock does not start over since it is measured from the inception of each account.
For example, Dr. Schwartz, a family physician in Pennsylvania, intends to covert his profit sharing plan account into a Roth IRA later this year as he will be age 55 in December. By the time he turns 60 in December, 2014, he will have satisfied both the 5-year requirement and the age 59-1/2 requirement. Even if he contributes additional money to the Roth IRA or makes additional conversions in the coming years, he can commence tax-free withdrawals in December 2014 and will not have to wait five years following each contribution.
There are several good reasons why you should want to move your retirement assets into a Roth IRA account:
1. Although profit sharing plans and pre-tax IRAs are great and help you defer tax, you will ultimately pay ordinary income tax on all of the money. Conversely, all of the growth in a Roth IRA can be tax-free, not tax-deferred, making it at least one-third more valuable. It is most advantageous to pay any tax upon converting with non-IRA funds so that all of the money in the IRA works for you and builds up tax-free.
You not only have the opportunity to build up money during your working years, but Roth IRA money is not subject to the minimum required distributions commencing at age 70-1/2 – a rule which applies to regular IRAs and Profit Sharing Plans – so the funds can remain in your account indefinitely. Upon your death, through your beneficiary designation, you can pass the assets to your children or grandchildren and they can take continued tax-free distributions over their lifetimes. This makes it a multi-generational tax-savings strategy.
Dr. Schrager, a New Jersey internist, has sufficient after-tax investments so that she does not need her retirement plan funds during her retirement plan years. By transferring them into a Roth IRA, she will not be subject to withdrawals which normally commence at age 70-1/2. It is her intention to leave all of her retirement monies to her sons at the time of her death, which gives them a lifetime of tax-free income. This is truly the gift that keeps on giving since tax-free growth continues into the next generation.
2. Anticipating the increase in tax brackets starting in 2011, paying tax on this money upon conversion to a Roth in 2010, makes particularly good sense.
3. As personal wealth increases, many physicians find that their incomes during retirement (because of their investments, retirement plan distributions, social security, rental income, etc.) is similar to their income during their careers and they continue to experience high-marginal tax brackets.