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Chapter 5: Roth Retirement Plans
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5.8.01
Roth plan or traditional? It’s all about the price tag
A Roth IRA is a nice asset to own. It offers the ability to generate income tax-free
investment accumulations that can be spent in retirement or left to heirs, and the additional
advantage of no required distributions during the participant’s life. And unlike with a traditional
IRA, the participant can withdraw his own contributions income tax-free anytime he wants to.
There theoretically could be some drawbacks that would make a Roth IRA “worse” to own
than a traditional IRA: For example, it’s possible that some states’ laws haven’t caught up with
the Roth idea yet, so that a Roth in such a state would be more vulnerable to state taxes and/or
creditors’ claims. Also, some planners speculate that a Roth is an “inferior” inheritance vehicle
because beneficiaries are more likely to cash it out quickly because it’s tax free, whereas they
might go along with deferring distribution of a traditional plan that they would have to pay income
tax on if they cashed it out. And (even aside from the income tax cost) the bump in taxable income
generated by a Roth IRA conversion could “look bad” on an application for college financial aid
or other means-tested benefit. But these drawbacks are speculative or applicable to few people.
The only significant widely-applicable drawback of a Roth plan is the cost. Generally, the
price is payment of income taxes on the amount going in to the Roth retirement plan—taxes that
could have been deferred (via a traditional retirement plan) until the money was taken out of the
retirement plan. The debate is not whether a Roth IRA is a good type of retirement plan to own.
The debate is about the price tag: Is it worth it, and can you afford it?
Which is better: to pay the taxes up front and get tax-free distributions later or to defer the
taxes?
A.
Analyzing the cost and benefits of a Roth conversion.
Professionals who have crunched
the numbers for many clients generally conclude that the following factors will result in a
Roth conversion’s being profitable for the converting participant and/or his beneficiaries:
1.
The income tax payable on the conversion will be less than would otherwise apply
to withdrawals from the account if it stayed in traditional form.
2.
The funds stay in the Roth account for some number of years, the longer the better.
This factor could mean (depending on the planner) that the money stays in the Roth
IRA for some absolute certain number of years to achieve a “break even point,” or
simply that it stays in the Roth account longer than it would have been allowed
(under the minimum distribution rules) to stay in a traditional plan.
3.
The income tax resulting from the conversion is paid with assets that are not inside
any retirement account.
4.
The Roth investments do not decline in value.
Not all professionals agree on the relative weight of these factors, and or even that all these
factors are relevant to the decision. Also, if one factor is positive enough, that factor alone may
make the Roth approach profitable even if the other factors are not present. For example, work
done by IRA expert Bob Keebler, CPA, and his firm has shown that prepaying a 35 percent tax
(via a 2010 Roth conversion) on retirement assets that would otherwise be taxed at 43.6 percent
(see
¶ 2.1.02 )can produce a profit for the client in just 10 years (compared with leaving all the