TO ROTH OR NOT TO ROTH, THAT IS THE QUESTION J. Scott Dillon Carruthers & Roth, P.A. 235 N. Edgeworth Street Greensboro, NC 27401 336.478.1119 jsd@crlaw.com
OVERVIEW The Rules Roth IRA Roth 401(k) Roth or Pre-Tax Deferrals Roth Conversions
PART I THE RULES
ROTH IRA Basics Same contribution limit as traditional deductible IRA $5,000/yr. or $6,000/yr. with catch up Phases out between $105,000 - $120,000 for single person or $166,000 - $176,000 for married filing jointly in 2009 This is combined limit for all Roth and pre-tax IRAs But, Roth contributions can continue past 70-1/2
ROTH IRA Basics Must keep in separate Roth IRA (can t commingle with pre-tax) Not subject to RMDs while owner alive Surviving spouse who rolls over not subject to RMDs either No deduction for contributions but qualified distributions are tax-free! Partial withdrawals come first from principal (relevant only for non-qualified distributions)
ROTH 401(k)/403(b) Basics Roth deferrals to 401(k)/403(b) plans available since 2006 Plan must also allow traditional pre-tax deferrals No income ceilings on ability to make Roth deferrals Employee s decision to defer as Roth is irrevocable (no conversion inside plan) Plan must separately account for Roth: Year of first deferral, Roth basis, and total Roth balance
Roth 401(k)/403(b) Basics Otherwise, regular 401(k) rules apply Subject to 402(g) limit ($16,500 in 2009/10 plus $5,500 catch up) ADP test applies unless plan is safe harbor 401(k) distribution restrictions apply (at termination or after age 59½) Qualified distributions are tax-free!
Qualified Distribution Qualified distribution is tax-free/penalty free Applies to principal and income Two requirements for qualified distribution: 5 year clock runs, and Qualified distribution event Attain age 59½ Death Disability First-time home buyer (IRA only)
Roth 401(k)/403(b) 5 year clock Each plan has separate clock Clock starts January 1 of year in which first Roth deferral made Roth clock tacks in plan-to-plan rollover Example: if first deferral occurs in Dec. 09, qualified distributions can be made starting Jan. 1, 2014
Roth IRA 5 year clock Each person has 1 Roth IRA clock, regardless of number of Roth IRAs Clock starts January 1 of year of first Roth deferral/conversion Example: if first contribution made 4/1/10 for 2009 tax year, qualified distributions can be made starting 1/1/14 In case of rollover from Roth 401(k), Roth 401(k) clock does not tack New 5 year clock if rollover Roth 401(k) to new Roth IRA
Roth rollover possibilities Can rollover qualified or non-qualified distributions Can rollover: Roth plan to Roth plan Roth IRA to Roth IRA Roth plan to Roth IRA Regular IRA to Roth IRA (subject to conversion rules) Regular plan account to Roth IRA (subject to conversion rules)
PART II ROTH OR PRE-TAX DEFERRALS (should I pay tax on the acorn or the tree?)
Tax rate issues Highest rate today = 35% Highest rate in 2011 = 39.6% (barring law change) Highest rate after 2011 =? High AGI can cause loss of itemized deductions Social security not taxed if income below $25,000 ($32,000 for joint return) Taxed at 85% otherwise
3 classes hurt by Roth Tax bracket goes down at retirement Will need distributions prior to maximizing advantage of Roth (will need more than RMD amount for living expenses) In Roth 401(k), can t afford to make Roth deferral equal to pre-tax deferral due to current tax liability; lose company match as result
6 classes helped by Roth Higher tax bracket at retirement Won t need money as fast as RMD schedule demands May need money before age 59½ Deferring as much as you can and would love to be able to defer more Forced savings for people who don t save anything other than retirement plan/ira contributions Reduce taxable estate for estate tax purposes by taxes on Roth contributions/conversions
A Tale of Scott and Howard Scott and Howard are age 50 Each in 40% bracket (federal & state) Investment funds grow at 10%/yr Defer until age 65 (check results at age 66) Available pre-tax salary available to invest $36,667 401(k) deferral (with catch up) - $22,000 Scott prefers Roth; Howard prefers pre-tax
Deferral Differences Pre-tax $ 401(k) deferral 40% tax Taxable side fund investment Scott (Roth) $36,667 $22,000 $14,667 $0 Howard (pre-tax) $36,667 $22,000 $5,867 $8,800
Results Scott s Roth 401(k) balance at 66 Howard s pre-tax 401(k) balance at 66 40% tax on Howard s 401(k) Howard s side fund balance at 66 Total for Howard Extra for Scott (10%) $790,894 $790,894 $316,358 $245,415 $719,951 $70,942
Four potential limits to high-income 401(k) participants wanting to defer more 402(g) - $16,500 plus $5,500 catch-up ADP 415 Plan limit Example: If ADP limit restricts Scott s 401(k) contribution to $10,000, $10,000 Roth deferral = $16,700 pre-tax deferral Example: Even if Scott can make full $22,000 401(k) deferral, deferring as Roth contribution means $8,800 less to spend on cars, vacations, i-phones, etc.
PART III ROTH CONVERSIONS
Roth IRA conversions Can convert traditional IRA to Roth IRA Price: Pay tax now on amount converted For 2009 only, modified AGI cannot exceed $100,000 $100,000 limit goes away in 2010 Options if convert in 2010 Include in 2010 (35% rate) Include ½ in 2011 and ½ in 2012 (?% rate)
Converting non-deductible IRAs to Roth Can convert non-deductible IRA contributions to Roth No tax on principal upon conversion; taxed only on converted IRA value in excess of basis Warning all IRAs must be converted pro rata Can t choose to convert after-tax IRA but not pre-tax IRA
Converting non-deductible IRAs to Roth Example: Howard has $50,000 after-tax IRA ($45,000 basis) and $50,000 regular IRA. If he converts after-tax IRA, must pay tax on $27,500 No 10% early distribution penalty on conversion before 59½
Rollover pre-tax plan to Roth IRA Can rollover pre-tax account in qualified plan directly to Roth IRA Same rules as Roth IRA conversion $100,000 income limit in 2009 Current taxation (2 year deferral option in 2010) Must have distributable event under plan Available for participants and beneficiaries
What if I make a mistake? After converting, can unconvert (recharacterize) all or part of Roth IRA back into pre-tax IRA on or before due date of tax return for year of conversion (as extended) After unconverting, you get a re-do --can reconvert back to Roth IRA in next tax year (or after 30 days if longer)
What if I make a mistake? Example: Sally converts $100,000 pre-tax IRA into Roth in 2010. Extends 2010 tax return. IRA drops to $50,000 as of 10/1/11. Sally unconverts on 10/1/11 and reconverts on 1/1/12 After converting, consider separating asset classes (i.e., stocks & bonds) into 2 Roth IRAs If one drops and other increases, apparently you can unconvert only the one that drops
Questions to ask before converting Do I expect tax rate on conversion to be higher than rate on distribution? Do I have funds available to pay taxes from outside of IRA? How many years of tax-deferred growth can I expect? Will my withdrawals exceed RMD amount regardless? Do I expect to have substantial taxable earnings after I start drawing social security? What effect will converting have on my tax bracket?
IRA comparison Larry, Mo, and Curly each: Have $500,000 in pre-tax rollover IRA Have $200,000 in outside taxable savings Are in 40% combined federal/state tax bracket Are age 65 Cash out at age 90 Earn 10%/yr on all investments Have no need for plan distributions
IRA comparison Larry keeps $ in pre-tax IRA Reinvests RMDs in savings (after paying taxes). Invests savings after-tax. Mo converts to Roth, paying tax from pre-tax IRA. No RMDs Invests savings after-tax Curly converts to Roth, paying tax from savings ($0 savings left). No RMDs
Results Larry Mo Curly IRA type Pre-tax Roth Roth Conversion tax paid from N/A IRA Savings Outside savings at 90 2,350,132 $858,374 $0 Pre-tax IRA at 90 $1,935,736 $0 $0 Tax on IRA at 90 (774,302) $0 $0 Roth IRA at 90 $0 $3,250,412 $5,417,353 Total $3,511,566 $4,108,786 5,417,353 % of Curly 65% 76% 100%
Retired couple; Pre-tax IRA; Main example John and Mary, married couple Both age 65, retired Social security = $20,000/year Taxable investments = $220,000 Pre-tax IRA = $200,000 File joint return with standard deduction (2008 rates) Living expenses = $61,200/year + taxes Earnings rate = 10%
Retired couple; Pre-tax IRA; Main example Withdraw $25,000/year from IRA $5,800 total taxes (all sources) $19,200 for remaining living expenses ($20,000 S.S. + $22,000 inv. earnings + $19,200 IRA = $61,200 needed to live) Result: IRA is empty at age 81 Outside savings carries until just before age 90
Retired couple; Roth IRA Conversion Same facts as previous example except convert to Roth IRA and pay taxes over 2 years from outside savings Taxes on conversion are $51,000 Continue drawing $22,000/yr from savings even though exceeds earnings Annual income taxes are much less IRA distributions aren t taxable Neither is social security Results Outside savings depleted at 83 At that point, start drawing $41,200 from Roth IRA Roth IRA lasts to age 94
After-Death Options Beneficiaries can convert inherited pretax IRA to Roth IRA Beneficiaries can rollover inherited pretax qualified plan to inherited Roth IRA RMDs from inherited Roth IRAs same as RMD from inherited pre-tax IRAs based on beneficiary s life expectancy
Beneficiary Example Assumptions Ben converts $100,000 pre-tax IRA to Roth IRA at age 65 8% annual return before 65 and 6% after Combined tax rate of 27.75% Ben takes no IRA distributions and dies at age 85 Ben s 55 year old son, Jerry, is beneficiary Jerry receives RMDs only
Beneficiary Example Results Jerry s Age Total Taxfree RMDs Remaining IRA balance Total Roth IRA Benefit Advantage over Tradition IRA 65 $183,446 $477,225 $660,671 $296,619 70 329,132 475,564 804,696 360,776 75 528,318 413,498 941,816 426,990 80 804,481 244,452 1,048,933 482,105 85 1,086,191 0 1,086,191 510,964