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A couple of years ago, I was invited to a presentation put on by an aggressive financial planner about all the reasons I and other tax professionals should try to convince our clients to begin investing in Roth IRAs instead of traditional IRAs and 401(k) plans.
What did I learn? That if those of us in the audience suggested our clients convert their retirement accounts to Roth IRAs, the financial planning company would make a fortune.
Is there any real value in switching from a 401(k) or IRA to a Roth IRA?
That’s a tough question to answer, especially since the IRS isn’t currently allowing taxpayers to spread out over a two- to four-year period the taxes they would be required to pay.
When you transfer funds from an IRA to a Roth IRA, the IRS requires you to pay taxes as though you’ve completely cashed out the account. And if you’ve transferred a large sum, it can put you into a much higher tax bracket.
If you’re going to pay on all those savings right now, what are the benefits of moving the funds to a Roth IRA?
For some people, especially those making the switch early in life, transferring investments to a Roth IRA works out well because the tax-free earnings make up for the taxes paid on making the switch.
On the other hand, I have seen people move $500,000 to a Roth IRA and lose 50 percent to 80 percent to sudden market downturns. Those people paid their taxes to transfer those funds to a Roth, and they ended up with far less than they ever had.
Also, bear in mind that once you open a Roth IRA, you cannot use those funds for five years without paying penalties.
Strategies for transferring funds
I suggest transferring the money from a traditional IRA to a Roth IRA a little bit at a time. By doing careful tax planning, you can move the money from your IRA or retirement account without raising your tax bracket.
In some cases—if you’re a senior with high medical expenses, for example—you might even be able to move a certain amount of money tax-free.
You can also start funding Roth accounts over the course of your employment. Many employers that offer 401(k) accounts also offer a Roth option. That means you can put your retirement contribution directly into a Roth 401(k) up to the annual limits. For 2013, the limit is $17,500 ($23,000 for those age 50 and above). Although you won’t get a deduction for your retirement contribution this year, it will grow tax-free until you retire.
Eva Rosenberg, EA is the publisher of TaxMama.com, where your tax questions are answered. She is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com and tax courses you might enjoy at http://www.cpelink.com/teamtaxmama.
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