What a boring looking topic. But Roth IRA conversions from regular IRAs are hot news this year for several reasons. First because of a one year special income tax smoothing on the amount converted from a regular IRA to a Roth IRA in 2010. What this means is that instead of paying income tax in 2010 on the entire amount converted from a regular IRA to a Roth IRA in 2010, you can elect to pay income tax on one-half of the 2010 conversion amount in 2011, and pay income tax on the other one-half of the 2010 conversion amount in 2112. Or you can simply elect to pay the tax on the whole amount in 2010 as you normally would have to do. Decisions on this tax election will of course depend on various personal factors including projected taxable income and estimates of tax brackets in 2011 and 2012 and depending possibly on some of the considerations below.
Regular IRA to Roth IRA conversions are also in the news this year because beginning in 2010, and possibly beyond 2010, there are no limits on the dollar amount of a regular IRA that can be converted to a Roth IRA. Until 2010 one could not and cannot convert to a Roth IRA if your modified adjusted gross income exceeded $100,000, so removing the income limits will be a big advantage for higher income taxpayers with large IRA balances. Also, of course, it's also a great benefit for the IRS since it will speed up their tax collection on tax-deferred IRA balances.
I've recently read quite a few retirement specialists, including several who have written books on Roth IRAs and/or who have subscription-based retirement newsletters. Most of them do not write clearly on the issue of potential taxes or penalties on some Roth IRA distributions. The main reason for a Roth IRA in the first place is that future earnings or gains in a ROTH IRA will not be taxed either in the Roth IRA or when withdrawn. So to hear confusing inforamtion that some distributions can be taxed is off-putting to say the least. I was confused by this for some time.
Surprisingly, the clearest discussion of taxation and non-taxation of Roth IRAs that I have seen is at the IRS website. http://www.irs.gov/publications/p590/ch02.html#en_US_publink10006523
There are two types of legally permissible non-taxable distributions from Roth IRAs: "qualified" and "non-qualified". "Qualified" distributions were the original basic plan of Roth IRAs. If you hold your Roth IRA contributions in the Roth for five years and you are 59 1/2 years old or older, you can then withdraw whatever you like and pay no income tax or penalty. Period.
"Non-qualified" non-taxable distributions are possible due to several legally defined exemptions from income taxation and penalties if you are either under 59 1/2 or haven't held the assets five full years or both. Basically you can always remove at any time a dollar amount up to the total of what you have put into or converted into your Roth IRA less any prior year withdrawals. So if you need the money for whatever reason or just want to take some out every year, you may do so. Let me say it a different way: if you have put or converted $200,000 into your Roth and have made $15,000 in dividends or capital gains on it so far, you can at any time remove cumulatively up to $200,000 from your Roth IRA tax-free and penalty-free even if you only set up the Roth IRA six months ago. After all it's your money and you already paid the income tax on that amount you put in or converted into the Roth IRA, so this should be a no-brainer. But the experts have not explained this very well in most cases. The $15,000 of earnings or capital gains you've made in the Roth IRA need to be held for five years before payout unless you want to pay both income tax and a 10% penalty on withdrawing it.
Basically that's the whole story. The IRS has a very thorough explanation of all the exemptions as well as forms for figuring it all out at the website above.
If you been reading me for a while, you know that I've been considering cashing out my and my family's IRAs this year for a variety of reasons you can read about here: http://tinyurl.com/ycm5z33 http://tinyurl.com/yaf2q28 Some of the reasons may be somewhat controversial but others are simple rational considerations of taxation and inflation probabilities. For someone facing mandatory annual and annually increasing Required Minimum Distributions (RMDs) from regular IRAs, getting pushed into higher and higher tax brackets as you get older is a reality.
Converting a regular IRA into a Roth IRA means paying exactly the same income taxes you would pay if you were just cashing out your IRA completely. Both are, in effect, cashing out the regular IRA, except in the Roth instance your are cashing out directly into a new Roth IRA. The advantage of the Roth IRA choice is that any income or gains you make in the Roth will be tax-free whereas what you simply cash out of a regular IRA and invest in a pesonal private will produce potentially taxable income going forward.
Suppose you have enough money in the current regular IRA to make two different kinds of accounts, and you'd also like to spread out the income taxes on the cash-out and/or Roth IRA conversion over four years instead of one or two years. For example, let's say you want to put part of your money coming out of the regular IRA into tax-free municipals or long term growth assets and put another part of your investments into high yield investments or short term capital gains possibilities such as gold or penny stocks or whatever you choose. Obviously the municipals and slow growth long term investments would better go in the new taxable account, and the high yield and short term capital gains investments would better be bought in the new Roth IRA account.
Let's say further that you have $500,000 in your regular IRAs this year and will be facing RMDs next year at age 70 or 71. The first year you will have to take out $19,000 and pay tax on it. Given the IRS's annual RMD escalation schedule and based on a 6% return each year, in ten years you'd be up to withdrawing and paying tax on $32,500 that year, and ten years after that the RMD will have escalated, year by year, to $45,100. You have to withdraw and pay tax on these amounts every year whether you need the money or not. This is the "bracket creep" taxation issue. Also in so doing you are spending down the value for any possible heir. http://tinyurl.com/ybuas4c
If you took all $500,000 out of your regular IRA this year or next either as a simple cash out or by conversion to a Roth IRA, you would pay roughly $150,000-$160,000 in income tax on it. If you cashed out $125,000 this year and $125,000 next year and then converted the remaining $250,000 next year into a Roth IRA, you could pay income tax on one-fourth of the $500,000 each year for 2009, 2010, 2011, and 2012. The tax would be roughly $18,000 per year or $72,000 total, or less than one-half of the total tax you would pay by doing it all at once! Bear in mind that these are rough calculations and do not take any state or local taxes into consideration nor possible tax rate increases. The totals however are so strikingly different for the two approaches that you couldn't lose by doing the four year income tax spread-out. And you could do the whole cash out and Roth IRA conversion between now and January 3, 2010 and get the assets bought in each new account according to the new plan. Naturally you'd have to set aside sufficient funds (~$72,000) to pay the taxes for the four years which you probably will NOT want to take out of the current IRA for reasons I won't get into today.
Meanwhile you'll have your new "low tax" taxable account with one-half of your cash-out and your "no tax" Roth IRA with the other one-half, with NO RMDs to pay every year, and you'll stay in a fairly low tax bracket going forward.
Let me repeat, as I always do here, that I am not a financial advisor, nor a money manager except for myself and family, and certainly not a tax expert, nor an accountant, and definitely not a lawyer. I am just a private investor. Anything I say here is just what I am thinking for myself based upon my own research and should be seen entirely as my "financial diary" and not as advice to anyone who reads it. If you get interested in the concepts, consult your own professional advisers as I will be doing with mine. One other caveat: I have not spoken about 401ks and other retirement plans as the rules are different, and I have none of those plans. I am told that some 401k plans have a Roth IRA option and others do not.
There are some real advantages to cashing out or converting IRAs to Roth IRAs right now and next year which m
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