From ancient days, many have pursued the ability to transform something common (lead, for example) to something precious (gold). Although the alchemist’s dream was never realized, people’s interest in the prospect of “a free lunch” continues. My cynical nature (polished shiny by years on Wall Street) usually keeps me far away from anything which seems too good to be true (the answer is “false” most of the time). But, when I learned about the details of the ROTH IRA conversion, my skepticism melted. This might be one of the best things I’ve heard about in a long time. Read on…
In 1974, the U.S. government established the Individual Retirement Account (IRA). It was (and is) a great way to save money over the course of one’s working career to supplement retirement income. One benefit of the IRA is that it could be funded with pre-tax dollars. Another benefit is that the assets in the account can grow, tax-free, until the assets are taken out. Anyone with a HP 12-C calculator can tell you the power of compounding – the longer the time-frame, the greater the benefit.
In 1997, the government created the ROTH IRA. In many ways, the ROTH IRA was a huge improvement over the traditional IRA. For one thing, contributions are made after tax and distributions, including all investment gains, are tax free. Also, one can pull money out of the account before retirement as the need might arise (and certain conditions are met). Unlike the traditional IRA, there are no required distributions – if one doesn’t need the funds in retirement, they can continue to grow, tax free and then be passed on to one’s heirs. Too good to be true? Well actually, yes. Congress limited who could contribute to a ROTH IRA based on income. So, high income earners (over $100,000) were effectively shut out of this wonderful investment vehicle.
Enter the new decade. I’m still trying to figure out why this happened, but in 2010 the income limitation has been removed for ROTH IRA conversion. So now anyone can convert IRA assets into a ROTH IRA. But, like so many things with the government and retirement accounts, there is a catch. One must pay taxes upon the taxable amount of the IRA assets rolled over. In my view, the key factor in the decision to convert or not comes down to whether the tax-free-forever nature of the ROTH IRA is worth the tax payment today. There are other complications (which frankly make my head hurt a bit to consider), but the choice seems to boil down to short-term payment vs. long-term gain.
One can find ROTH IRA conversion calculators plastered all over the Internet. I’ve tried to use a few of them, but always got bogged down in the details. How am I supposed to know what my tax rate will be in 20 years!? So, happy was I when I found this simple questionnaire. It doesn’t tell me how to convert, but simply tells me whether or not I would be good candidate for conversion. Here it is:
Roth IRA Questionnaire
(1) Will you be in a high tax bracket in Retirement?
(a) YES – I expect my tax bracket to be higher in retirement (3 points)
(b) NO – I expect my current tax bracket is higher (0 points)
(2) Are outside assets available to pay tax on conversion income?
(a) YES – I have taxable assets available to pay tax (2 points)
(b) NO – I would need to use IRA assets to pay tax (0 points)
(3) Do you plan to pass IRA assets to heirs?
(a) I do not plan on needing any of my IRA assets in retirement (2 points)
(b) I plan to use some of my IRA assets in retirement but not all (1 point)
(c) My IRA assets will be my main source of income in retirement (0 points)
(4) How long is your investment horizon for IRA assets?
(a) My investment horizon is more than 10 years (2 points)
(b) My investment horizon is between 5 and 10 years (1 point)
(c) My investment horizon is less than 5 years (0 points)
(5) Does your IRA investment strategy seek capital growth?
(a) YES – Long term appreciation is a primary objective (LT Rate of Return > 6%) (1 point)
(b) NO – My investment strategy is very conservative (LT Rate of Return < 6%) (0 points)
(6) Do you have any tax basis in your current IRA?
(a) YES – A portion of my IRA will not be subject to tax upon distribution (1 point)
(b) NO – all assets in my IRA are tax-deferred (0 points)
0 – 3 : Roth Conversion may not be a good option
4 – 7 : Roth Conversion should be considered
8 – 12 : Roth Conversion should be strongly considered
That’s it – six simple questions, one score. If you think you might be a good candidate for ROTH IRA conversion, talk to your tax account or financial advisor right away. If done properly, the Roth IRA conversion can fulfill, in some small measure, the alchemist quest, not turning lead into gold, but turning taxable retirement assets into tax-free retirement assets. It may not be magic, but in these days of lowered expectations, I will take any good news I can find.