Beverly, I have a question I plan to talk to a tax planner about -- but after reading your article, if you feel you could help steer me... I work for a city utilities company. We changed to a state retirement plan, which leaves me with $35,000 that I rolled over to a traditional IRA. Would I be better off to roll over to a Roth IRA? With a Roth IRA can you withdraw for higher education expenses of your children? Thanks in advance. Cindy Dillard
You're right to speak to a tax planner, since only someone with full knowledge of your financial situation can determine whether you're better off in a Roth or traditional IRA, but I can give you a few rules of thumb.
The money you contribute to a traditional IRA is contributed
taxes have been assessed. That $35,000 you contributed to your employer's plan was likely deducted from your salary before taxes had been taken out. And when you rolled it into an IRA, you did so tax-free. When you withdraw that money in retirement, you'll owe ordinary income tax on each amount you withdraw.
Roth IRAs, though, don't offer any upfront tax benefit. Rather, the contributions are made with after-tax money, and the money that's withdrawn in retirement is taken out completely free of taxes.
Roth IRAs are typically better for people who expect to be in a higher tax bracket when they retire. Think about it: If you're in the 27% bracket now (which goes from $46,701 to $112,850 for married couples; $23,351 to $56,425 for singles) but expect to be in the 30% bracket in retirement, it's better to pay the 27% tax now and withdraw the money tax-free when you're in the higher bracket.
Conversely, if you expect to be in a lower bracket in retirement, you're better off getting the deduction now while you're paying more in taxes, and paying tax on the withdrawal at your lower rate in retirement. If your bracket doesn't change, it's pretty much a wash.
Also, Roths can be great estate-planning tools. So if you don't expect to need to use the money in your IRA (say, if you have enough in your outside, taxable accounts to fund your retirement) and don't want to be forced to withdraw money at age 70 1/2 (as you would in a traditional IRA), you can maximize the IRA's growth and options for your beneficiaries by converting.
So let's say converting to a Roth still sounds pretty good. To do so, your modified adjusted gross income must be $100,000 or less, regardless of whether you file singly or jointly. (The conversion amount does not count toward the $100,000 cap, but it does increase your income for the year for regular tax purposes.) But here's the main concern: You'll need to pay tax on that $35,000
. You absolutely should not roll that money into a Roth unless you have outside funds to pay that tax -- taking money from the IRA itself to pay the tax on the conversion is self-defeating.
As for withdrawals for higher education, you've already paid tax on the money you contributed to a Roth, so you're always allowed to withdraw any amount up to what you put in without paying tax or penalty. If you want to withdraw any gains to pay for higher education expenses, though, the rules are the same as for withdrawing from a traditional IRA: You'll owe income tax on the gain, but the distribution will
be subject to the 10% penalty.
Hello Beverly,Say an investor has $10,000 in a traditional IRA and wants to convert this amount to a Roth IRA. Can a portion of the total amount (say $5,000) be converted in one year, then the rest converted in another year? Or must the entire conversion (traditional IRA to Roth IRA) occur in one tax year?The IRS Web site seems to imply the entire amount must be converted (no surprise there), but I've read implications of being able to do a partial conversion of a traditional IRA to a Roth IRA. Partial conversions help people who want to convert but not bump themselves into the next higher tax bracket.If you'll possibly be covering this issue in one of your future TheStreet.com columns, I'll be on the lookout for it.Thanks in advance for answering this question,Jay Heney
I'm not sure what part of the
IRS Web site you were reading, but you absolutely are able to convert just part of a traditional IRA into a Roth account. Indeed, this is a very smart strategy for investors who want to convert to a Roth but don't have the outside funds to pay the tax on the conversion. By converting a series of smaller amounts, you can minimize the tax hit in any given year.
You have two options for executing your partial conversion: You can do a trustee-to-trustee transfer, or withdraw and redeposit the funds yourself. Trustee-to-trustee transfers are preferable, largely because they're more streamlined, and you don't run the risk of a penalty. All you do is alert the trustee of your traditional IRA (be it a brokerage, fund company or bank) that you want to roll part of your IRA (in this case, $5,000) into a Roth.
If you want the same trustee to hold your Roth, the transaction should be completed almost immediately. If you want another trustee to be the custodian of your Roth, the trustee of your traditional IRA will transmit the funds you want to convert directly to the trustee of the Roth account.
You're also able to withdraw the $5,000 from your traditional IRA yourself, and send a check to the new custodian of your Roth. Big caveat, though: You have just 60 days to complete the transaction, otherwise you'll owe a 10% penalty plus income tax on the amount you withdrew.
Remember, to convert even a small amount of a traditional IRA, your modified adjusted gross income can't exceed $100,000 (regardless of whether you're married or single; married couples filing separately may not convert).
For more information, check out
IRS Publication 590, "Individual Retirement Arrangements."
Roths are great, assuming the bull can be roused from the dead. I know you may not take this question seriously, but here goes: If by some small, minuscule chance we go Japanese and the bear prevails for a decade or two, is a loss on a Roth deductible (capital loss?), seeing that the gains are not taxable? RP Koscinski
Generally, because IRAs are tax-advantaged, investors are not able to claim any losses incurred inside of an IRA. The same goes for a Roth, although there's a minuscule loophole that -- while completely legitimate -- is probably only useful to a small number of investors.
The problem is twofold. First, you must liquidate all of your Roth IRA accounts to claim a loss. If you close out all of your Roth IRA accounts, and the total distribution is less than your total contributions, you might be able to claim the loss.
Now comes the second sticking point: The loss is only deductible as a miscellaneous itemized deduction --
as a regular capital loss. Regular capital losses (those that occur in taxable accounts) can be used to offset any taxable gains. And if the losses exceed the gains, you can offset up to $3,000 in ordinary income, saving any excess to deduct in future years. Not so with losses from a liquidated Roth, though. Because they're only deductible as a miscellaneous itemized deduction, the losses must exceed 2% of your adjusted gross income (AGI) before they can be deducted. So if your AGI is $100,000 and you've lost $7,000 in your Roth, only $5,000 of that loss is deductible. (Two percent of $100,000 is $2,000, so only the losses that exceed $2,000 are deductible, in this example.)
In order to more easily reach the 2% threshold, you can bunch your Roth losses with other miscellaneous itemized deductions, such as any unreimbursed business and travel expenses; professional association and union dues; cost of looking for a new job; work uniforms; tax advice and preparation fees and some legal fees. For more on miscellaneous itemized deductions, see
Tax Time -- What You Can and Can't Deduct.
Keep in mind, though, that once you close your Roth to claim the loss deduction, you can't put the remaining money back into a Roth (or any other sort of IRA). You can, of course, open a new Roth account, but your contribution will be limited to the $3,000 annual contribution limit ($3,500 if you're 50 years of age or older). But you're still essentially forgoing the future benefit of a Roth for a deduction today. The further you are from retirement, the less sense this makes -- unless, of course, you really are expecting a 20-year bear market. I'm not.