What Good Hath Roth?

On May 24, 1844, Samuel P. Morse officially opened the Baltimore – Washington telegraph service by sending the message "What hath God wrought?" The telegraph led to the telephone. The telephone led to the cell phone. Following the trail of the cell phone leads to my teen-age daughter. I too lament, "What hath God wrought?"
Moving from the meta-physical and inter-personal to the financial, we can ask: "What good is a Roth IRA?" I admit that, when Roth IRAs were introduced, I thought they were a ploy to get people to pay taxes sooner rather than later. Looking more closely at the provisions and the mechanics of this ownership form has convinced me that Roth IRAs have a place in most people's retirement portfolio.

History

Roth IRAs were created by the "Taxpayer Relief Act of 1997." Under the Act, an individual may establish an IRA under which all distributions are free from federal income taxation if certain conditions are met. There is no income tax or penalty tax on distributions if the Roth IRA has been in existence for five years and the owner would qualify for a penalty-free withdrawal from a Traditional IRA—the owner attaining age 59 ½ being the most common qualification. After the five year period, contributions can be withdrawn income tax and penalty tax free even if the owner is younger than 59 ½. If a distribution is made from a Roth IRA without meeting the requirements, there is a 10% penalty tax on it plus income tax is owed on any portion that wasn't previously taxed.
One feature of a Roth IRA is that it is not subject to the Required Minimum Distribution rules as long as it's owned by the Contributor or spouse. Non-spouse beneficiaries may maintain the Roth IRA in its tax-free state, subject to a new 5-year hold and Required Minimum Distributions. A non-spousal beneficiary has to take the balance of the account within 5 years, or start lifetime payments before the end of the calendar year following the year of the contributor's death. Generally, there are no IRD issues involved. Additionally, since they bypass probate, Roth IRAs can be an efficient way of passing assets to heirs.
There is a catch to Roth IRA contributions. A married couple cannot make a contribution to a Roth IRA if their Modified Adjusted Gross Income (MAGI) is over $176,000 ($120,000 if single). A conversion of a Traditional IRA to a Roth IRA is prohibited if the taxpayer's MAGI is over $100,000 (married or single). (This limit to conversions is removed as of 1/1/2010 by TIPRA. See "The Roth of Con(versions).")

Pay Now or Pay Later?

Whether it is financially advantageous to convert to a Roth IRA or not is based on tax rates at the time of conversion and at the time of withdrawal. For comparison purposes, let us assume that a 50-year old has $100,000 in a Traditional IRA and is in the 35% marginal tax bracket. He will withdraw all of the funds in 20 years. If he converts to a Roth IRA, he will owe $35,000 in taxes, which he has available in a taxable account. Let us further assume that all accounts earn 6% annually, although the taxable account pays tax on its growth annually. He can either keep the $100,000 in the Traditional IRA and pay taxes on withdrawal, plus have $35,000 grow at an after tax rate; or, he can convert the $100,000 to a Roth IRA and pay the $35,000 in taxes now. On the day after he converts the funds he is either in a much lower (15%), lower (28%), same (35%), higher (42%), or much higher (55%) tax bracket. The table below shows the after-tax outcome of these five scenarios.

	Roth IRA	After-tax Traditional IRA + Taxable Fund
Much lower tax rate	$320,714	$272,607 + $94,650 = $367,257
Lower tax rate	$320,714	$230,914 + $81,549 = $312,463
Same tax rate	$320,714	$208,464 + $75,228 = $283,692
Higher tax rate	$320,714	$186,014 + $69,374 = $255,388
Much higher tax rate	$320,714	$144,321 + $59,632 = $203,953

For the Traditional IRA + Taxable Fund to equal or exceed the value of Roth IRA, the marginal tax bracket must drop 9% or more immediately after the conversion.
Now, let us assume that the 50-year old wants to consider a Roth conversion, but doesn't have funds to pay taxes with, other than the IRA. He will owe ordinary income taxes plus a 10% penalty tax on funds withdrawn to pay taxes. This time, we assume tax rates change some time before withdrawing everything from the Traditional IRA in 20 years. Using the assumptions above, we have the following outcomes:

	Roth IRA - Taxes	After-tax Traditional IRA
Much lower tax rate	$195,995	$272,607
Lower tax rate	$195,995	$230,914
Same tax rate	$195,995	$208,464
Higher tax rate	$195,995	$186,014
Much higher tax rate	$195,995	$144,321

Even with the 10% penalty tax, it does not take much of a tax increase to make the Roth IRA worth more. A tax increase of 4% or more makes the Roth IRA beneficial, even if taxes are withdrawn from it.
The conclusion we can draw from this analysis is that: (1) if a Traditional IRA participant has outside funds to cover the taxes, a Roth IRA Conversion is advantageous as long as tax rates do not drop more than 9% immediately after conversion; (2) if a Traditional IRA partyicipant pays for the conversion from the Traditional IRA and incurs the 10% penalty tax, the Roth IRA Conversion is still beneficial if taxes rise 4% or more by the withdrawal date. These conclusions do not necessarily apply to new contributions—we are analyzing Roth Conversions only.

Take Backs; or, A Question of Character

We have looked at a number of "what-if's." Here is another "what-if": What if an IRA owner converts an IRA early in the year and the value goes down after that. For example, on January 2^nd the owner converts a $100,000 IRA to a Roth IRA. On December 1 the Roth IRA is worth $60,000. The owner would have a tax liability on $100,000 but would get no benefit from 40% of that liability (the tax paid on the value that disappeared). Fortunately, you can "take-back" a Roth Conversion as long as it is done by the filing deadline. This process is called re-characterization. The IRA custodian will have forms that provide the proper information to perform a re-characterization acceptable to the IRS.
Let us follow the mechanics of conversion and re-characterization. The owner converts a Traditional IRA to a Roth IRA in January, 2010. (The earlier in the year that you convert the IRA, the more time you will have to take advantage of any tax planning.) On April 1, 2011, he compares the Roth IRA's value to its conversion value. If the Roth IRA is higher, he pays tax on the lower conversion amount when he files his taxes. If the Roth IRA is lower, the owner re-characterizes it back into a Traditional IRA and cancels the tax liability. Re-characterizations take two weeks or more, so the owner wants to allow time to act before he has to file, although a taxpayer can also file for an extension to file as late as October 15^th.
If the owner re-characterizes the IRA, the money is back in a Traditional IRA but he wants it in a Roth IRA. The tax law says that re-characterized money can be re-converted by the later of the start of a new tax year or 30 days. The owner initially converted the IRA in the 2010 tax year. The money was re-characterized by April 15, 2011 for the 2010 tax year. Since he is past the end of the tax year, he waits 30 days and converts the Traditional IRA to a Roth IRA on May 15, 2011. The owner will pay taxes on the IRA's value when he files his taxes for 2011. Since the value is lower than when he initially converted the IRA, he will owe less tax on the conversion.
Setting aside the politics of deciding when we want to give the Government money to use or waste, Roth IRAs are an advantageous ownership form for most persons' retirement. They are an excellent estate planning tool: the owner is not forced to dissipate a Roth IRA through Required Minimum Distributions; Roth IRAs pass outside of probate as long as the estate is not the beneficiary; and, they can maintain their tax-free status for the heirs. Congress has made provisions that make converting a Traditional IRA to a Roth IRA especially advantageous in 2010. See the article "The Roth of Con(versions)".