As a result of new tax laws,many physicians willnow be able to takeadvantage of a Roth IRAfor the very first time in2010. And while not all financial expertsbelieve this news offers benefits acrossthe board, most are excited at the potentialsavings for wealthier taxpayers. "Forphysicians, this is unbelievable," commentsJames Lange, a national retirementand estate planning expert who isboth a CPA and an attorney. "It's a fabulousopportunity."
Previously, anyone with a modifiedadjusted gross income of $100,000or more did not qualify for a Roth IRAconversion. But the Tax Increase Preventionand Reconciliation Act (TIPRA),passed on May 17, 2006, changes this.Starting in 2010, all taxpayers—regardlessof income—can convert to a Roth.
Roth vs Traditional
What are the financial consequences?Lange feels the consequences are potentiallyhuge. To grasp the implications,one must first understand how a Rothdiffers from a typical IRA. As Langesays, "For most physicians, Roth IRAsjust aren't part of their vocabulary. Itdoesn't apply to them."
With a traditional IRA, contributionsare deductible and taxes are deferreduntil you retire and make withdrawals.At that point, taxes must be paid on contributionsas well as earnings. With aRoth, you pay taxes on your contributions(which are not deductible), butthen owe no taxes at withdrawal if youare older than age 591/2 and if theaccount is at least 5 years old. Thus,with a Roth, the account's earningsessentially grow tax-free.
To convert a traditional IRA to aRoth, taxes must first be paid on thedeductible contributions and earnings inthe traditional IRA. So physicians consideringa conversion must essentiallyevaluate which makes the most financialsense for their portfolio: a "pay now" or"pay later" scenario.
Several individual factorsshould be considered whendeciding whether to convert,according to Christine Fahlund,CFP®, senior financial plannerwith T. Rowe Price. Theseinclude time until retirement,tax bracket changes, how conversiontaxes will be paid, andeven emotional issues. Generally,the longer time until retirement,the more a conversioncan make sense. Those approachingretirement in the nextfew years or current retireesmay still benefit, but shouldcrunch the numbers carefully.
One of the most importantfactors, Fahlund says, is taxbracket—for several reasons.For instance, if your current taxbracket is much higher thanyour expected retirement taxbracket, then a conversionmight not be for you. At thesame time, Fahlund says there'soften no real way to projectyour retirement tax bracket since itdepends not just on personal circumstances,but on national issues. Lange,too, says most detractors of Roth IRAconversions bring up the possibility ofnational tax law changes. But he feelsthe most likely scenario is a taxincrease—making the Roth even moreattractive. As Fahlund says, "It's a birdin the hand if tax brackets do go up."
Another reason tax bracket becomesimportant is the conversion processitself. When converting, the dollaramount being converted is added toyour taxable income for that year—which may jump you to a higher incometax bracket. Since this should be avoided,it's best to work with your tax advisorand convert only an amount for thatyear that will keep you in the same taxbracket. For this reason, both Lange andFahlund recommend staggering conversionsover several years. "Physicians aregoing to be super-sensitive to the taxissues here," Fahlund comments. Sheadds, "[Most] physicians will have hugeretirement plans?maybe a third ofwhich will be gone in taxes."
American Association of Individual
Fahlund wrote an article in a pastthat presented a varietyof financial scenarios with variablessuch as investor age, conversionamount, nondeductible IRAs, withdrawals,tax brackets, and more. In themajority of cases, Roth IRA conversionsmade financial sense, with a few exceptions.For instance, given certainassumptions, a 45-year-old making a$25,000 conversion would pay $7188in taxes and receive roughly $20,000more in retirement income. A 55-yearoldconverting $50,000 would pay$14,375 in taxes and gain approximately$13,500 in income. Both scenariosassumed a 25% tax bracket, which didnot change in retirement, and withdrawalsmade over a 30-year period.However, if the investor's tax ratedropped to 15% after retirement, keepingthe traditional IRA would give the45-year-old an extra $3000 roughly; the55-year-old, an extra $8000. The scenarioalso assumed the taxes due to convertwere paid out of separate funds—not the existing IRA.
Indeed, both Lange and Fahlund cautionagainst paying conversion taxes outof the existing IRA because it changesthe financials greatly. "It doesn't work," Fahlund says. Not only does it decreaseinvested funds, but a 10% penalty willbe due on the amount taken out.There is no penalty for full conversion.This is yet another reasonwhy those who plan to convertmay want to staggeramounts. It avoids coming upwith the full amount of taxesfrom another source all in 1 year.Other things to know include:
•For conversions in 2010only, taxes due can be averagedover 2 years.
•Withdrawals from a Rothare considered assets taken fromcontributions first and earningssecond. Thus, some withdrawalsbefore age 591/2 may bepenalty-free.
•A Roth owner is not requiredto take minimum distributionsafter age 701/2 and canleave a Roth to a beneficiary.
Leave a Legacy
Retire Secure! Pay Taxes Later
Lange feels the last point isimportant for those who wantto leave a legacy. In his book,,published this past September by Wiley,he writes, "With respect to Roth IRAconversions, the better advice?is paytaxes now?. For the very-high-incomefamily, the benefit of a Roth IRA conversionis potentially phenomenal. An estimateis that a taxpayer's family couldbenefit by as much as twice the amountconverted." He goes on to draw theexample of a person in the 35% taxbracket who converts $1,000,000.Given certain assumptions, they willgain $286,416 in today's dollars in 20years; $725,616 in 30 years. Further, abeneficiary who inherits at age 45 andmakes minimum withdrawals while alsoreinvesting could potentially gain closeto $2,000,000 by age 85. (See charts.)
Besides leaving a legacy, Fahlundbrings up the aspect of investing thatgoes beyond the numbers. "Emotionally,I think the answer for most peopleis, go ahead and do it now," she comments."You would like to be looking ata honey pot [in retirement] that youdon't have to pay taxes on."
Fortunately, with the new rulestaking effect in 2010, there's still plentyof time to prepare. To start, visitthe IRA analyzer tool at www.troweprice.com.