When Clients Should Open or Convert to a Roth IRA: These Versatile Accounts Belong in Every Adviser's Retirement Strategy Toolkit
[ILLUSTRATION OMITTED] Roth IRA accounts are frequently recommended by advisers but sometimes in what seems a cookie-cutter fashion, assuming everyone should open a Roth account and that everyone with a traditional IRA should convert it to a Roth at any time. In fact, however, whether a Roth is better for the client depends on multiple factors. This article addresses when and why a Roth account makes good sense, as well as best practices in the Roth conversion process. Using a Roth conversion most advantageously could generate a sizable after-tax return. Roth IRA accounts are frequently touted for their tax benefits, primarily qualified distributions that are tax-free (Sec. 408A(d)(l)). Qualified distributions under Sec. 408A(d)(2)(A) are those paid or distributed after the five-year period beginning with the first tax year for which the individual (or spouse) first contributed to the Roth account established for that individual and are made either: * On or after the taxpayer attains age 59 1/2; * To a beneficiary or the taxpayer's estate on or after the taxpayer's death; * On account of the taxpayer's disability; or * For a first-time home purchase (up to 110,000). Whether a Roth account makes sense depends on the taxpayer's current tax rate compared with his or her expected tax rate in retirement, when distributions will generally be made. The CPA can discuss tax rates with the client, along with the types and sources of income the client has now and anticipates later. Obviously, a big unknown is what future statutory tax rates will be. One could argue that, historically, tax rates are lower than in the past, and, therefore, they likely will only go up. However, one also has to consider that the higher rates were in effect before passive activity loss or at-risk rules were enacted and that no one knows what future rates will be. Generally, if a client's tax rate is expected to be much higher in his or her retirement years, a Roth account can provide value. The distributions will already have been taxed when initially contributed or converted to the Roth account. Unfortunately, however, the taxpayer may view the analysis as a cash flow issue. The Roth will provide no current tax benefit via a deferral of current income tax on contributions. If an individual anticipates being in a significantly higher tax bracket later in life, then it would be best to forgo a current-year tax deduction, such as that provided by a pretax retirement account contribution (e.g., to a Sec. 401(k) account or a traditional IRA) and to make Roth contributions or a conversion. Therefore, Roth accounts cannot be recommended across the board; every client's needs and resources must be analyzed. Most financial planning scenarios anticipate that individuals will live in retirement on perhaps 70% to 80% of their preretirement income and will have a lower tax rate. For them, a Roth account might not make sense. Other factors include the type of income received or expected in retirement, such as qualified dividends or tax-exempt interest. In addition, Roth IRAs are not subject to required minimum distributions (RMDs), so these accounts can grow far into retirement. Note, however, that designated Roth accounts ("Roth 401 (k)s") are subject to RMDs; therefore, a Roth 401(k) should be rolled over into a Roth IRA to avoid the RMD rules. Time-value-of-money concepts can help reinforce with clients the need to analyze Roth account planning. Example: Assume a 30-year-old has no retirement plan currently at work, so a traditional IRA contribution can provide an adjustment to arrive at adjusted gross income (AGI) in calculating his tax liability. He saves $100 every month and wants to put a year's worth of these savings ($1,200) into either a Roth account or a traditional IRA, along with the current-year tax savings he will realize from making a contribution to a traditional IRA. …