TO ROTH OR NOT TO ROTH,
THAT IS THE QUESTION
J. Scott Dillon
Carruthers & Roth, P.A. 235 N. Edgeworth Street
Greensboro, NC 27401 336.478.1119
The Rules
Roth IRA
Roth 401(k)
Roth or Pre-Tax Deferrals
Roth Conversions
OVERVIEW
PART I
THE RULES
ROTH IRA Basics
Same contribution limit as traditional deductible IRA
$5,000/yr. or $6,000/yr. with catch up
Phases out between $105,000 - $120,000 for
single person or $166,000 - $176,000 for married filing jointly in 2009
This is combined limit for all Roth and pre-tax IRAs
But, Roth contributions can continue past 70- 1/2
ROTH IRA Basics
Must keep in separate Roth IRA (can’t
commingle with pre-tax)
Not subject to RMDs while owner alive
Surviving spouse who rolls over not
subject to RMDs either
No deduction for contributions but
qualified distributions are tax-free!
Partial withdrawals come first from
principal (relevant only for non-qualified
distributions)
ROTH 401(k)/403(b) Basics
Roth deferrals to 401(k)/403(b) plans available since 2006
Plan must also allow traditional pre-tax deferrals
No income ceilings on ability to make Roth deferrals
Employee’s decision to defer as Roth is irrevocable (no conversion inside plan)
Plan must separately account for Roth:
Year of first deferral, Roth basis, and total Roth balance
Roth 401(k)/403(b) Basics
Otherwise, regular 401(k) rules apply
Subject to 402(g) limit ($16,500 in 2009/10 plus $5,500 catch up)
ADP test applies unless plan is safe harbor
401(k) distribution restrictions apply (at termination or after age 59½)
Qualified distributions are tax-free!
Qualified Distribution
Qualified distribution is tax-free/penalty
free
Applies to principal and income
Two requirements for qualified distribution:
5 year clock runs, and
Qualified distribution event
Attain age 59½
Death
Disability
First-time home buyer (IRA only)
Roth 401(k)/403(b) 5 year
clock
Each plan has separate clock
Clock starts January 1 of year in which
first Roth deferral made
Roth clock tacks in plan-to-plan rollover
Example: if first deferral occurs in Dec.
09, qualified distributions can be made
starting Jan. 1, 2014
Roth IRA 5 year clock
Each person has 1 Roth IRA clock, regardless of number of Roth IRAs
Clock starts January 1 of year of first Roth deferral/conversion
Example: if first contribution made 4/1/10 for 2009 tax year, qualified distributions can be made starting 1/1/14
In case of rollover from Roth 401(k), Roth 401(k) clock does not tack
New 5 year clock if rollover Roth 401(k) to new Roth IRA
Roth rollover possibilities
Can rollover qualified or non-qualified distributions
Can rollover:
Roth plan to Roth plan
Roth IRA to Roth IRA
Roth plan to Roth IRA
Regular IRA to Roth IRA (subject to conversion rules)
Regular plan account to Roth IRA (subject to conversion rules)
PART II
ROTH OR PRE-TAX DEFERRALS
(should I pay tax on the acorn or the tree?)
Tax rate issues
Highest rate today = 35%
Highest rate in 2011 = 39.6% (barring law
change)
Highest rate after 2011 = ?
High AGI can cause loss of itemized
deductions
Social security not taxed if income below
$25,000 ($32,000 for joint return)
Taxed at 85% otherwise
3 classes hurt by Roth
Tax bracket goes down at retirement
Will need distributions prior to maximizing
advantage of Roth (will need more than RMD amount for living expenses)
In Roth 401(k), can’t afford to make Roth deferral equal to pre-tax deferral due to
current tax liability; lose company match as result
6 classes helped by Roth
Higher tax bracket at retirement
Won’t need money as fast as RMD schedule demands
May need money before age 59½
Deferring as much as you can and would love to be able to defer more
Forced savings for people who don’t save anything other than retirement plan/IRA contributions
Reduce taxable estate for estate tax purposes by taxes on Roth contributions/conversions
A Tale of Scott and Howard
Scott and Howard are age 50
Each in 40% bracket (federal & state)
Investment funds grow at 10%/yr
Defer until age 65 (check results at age 66)
Available pre-tax salary available to invest
$36,667
401(k) deferral (with catch up) - $22,000
Scott prefers Roth; Howard prefers pre-tax
Deferral Differences
$8,800
$0 Taxable side
fund investment
$5,867
$14,667 40% tax
$22,000
$22,000 401(k) deferral
$36,667
$36,667 Pre-tax $
Howard (pre-tax) Scott
(Roth)
Results
$70,942 Extra for Scott (10%)
$719,951 Total for Howard
$245,415 Howard’s side fund balance at 66
$316,358 40% tax on Howard’s 401(k)
$790,894 Howard’s pre-tax 401(k) balance at 66
$790,894 Scott’s Roth 401(k) balance at 66
Four potential limits to high-income
401(k) participants wanting to defer
more
402(g) - $16,500 plus $5,500 catch-up
ADP
415
Plan limit
Example: If ADP limit restricts Scott’s 401(k) contribution to $10,000, $10,000 Roth
deferral = $16,700 pre-tax deferral
Example: Even if Scott can make full $22,000 401(k) deferral, deferring as Roth
contribution means $8,800 less to spend on cars, vacations, i-phones, etc.
PART III
ROTH CONVERSIONS
Roth IRA conversions
Can convert traditional IRA to Roth IRA
Price: Pay tax now on amount converted
For 2009 only, modified AGI cannot
exceed $100,000
$100,000 limit goes away in 2010
Options if convert in 2010
Include in 2010 (35% rate)
Include ½ in 2011 and ½ in 2012 (?% rate)
Converting non-deductible
IRAs to Roth
Can convert non-deductible IRA
contributions to Roth
No tax on principal upon conversion; taxed
only on converted IRA value in excess of
basis
Warning – all IRAs must be converted pro
rata
Can’t choose to convert after-tax IRA but not pre-tax IRA
Converting non-deductible
IRAs to Roth
Example: Howard has $50,000 after-tax
IRA ($45,000 basis) and $50,000
regular IRA. If he converts after-tax
IRA, must pay tax on $27,500
No 10% early distribution penalty on
conversion before 59½
Rollover pre-tax plan to Roth
IRA
Can rollover pre-tax account in qualified
plan directly to Roth IRA
Same rules as Roth IRA conversion
$100,000 income limit in 2009
Current taxation (2 year deferral option in 2010)
Must have distributable event under plan
Available for participants and beneficiaries
What if I make a mistake?
After converting, can unconvert
(recharacterize) all or part of Roth IRA
back into pre-tax IRA on or before due
date of tax return for year of conversion
(as extended)
After unconverting, you get a “re-do” --can
reconvert back to Roth IRA in next tax
year (or after 30 days if longer)
What if I make a mistake?
Example: Sally converts $100,000 pre-tax IRA into Roth in 2010. Extends 2010 tax return. IRA drops to $50,000 as of 10/1/11. Sally unconverts on 10/1/11 and reconverts on 1/1/12
After converting, consider separating asset classes (i.e., stocks & bonds) into 2 Roth IRAs
If one drops and other increases, apparently you can unconvert only the one that drops
Questions to ask before
converting
Do I expect tax rate on conversion to be higher than rate on distribution?
Do I have funds available to pay taxes from outside of IRA?
How many years of tax-deferred growth can I expect?
Will my withdrawals exceed RMD amount regardless?
Do I expect to have substantial taxable earnings after I start drawing social security?
What effect will converting have on my tax bracket?
IRA comparison
Larry, Mo, and Curly each
: Have $500,000 in pre-tax rollover IRA
Have $200,000 in outside taxable savings
Are in 40% combined federal/state tax bracket
Are age 65
Cash out at age 90
Earn 10%/yr on all investments
Have no need for plan distributions
IRA comparison
Larry keeps $ in pre-tax IRA
Reinvests RMDs in savings (after paying taxes). Invests savings after-tax.
Mo converts to Roth, paying tax from
pre-tax IRA. No RMDs
Invests savings after-tax
Curly converts to Roth, paying tax from
savings ($0 savings left). No RMDs
Results
$0
$0 (774,302)
Tax on IRA at 90
100% 76%
65%
% of Curly
5,417,353
$4,108,786
$3,511,566 Total
$5,417,353
$3,250,412
$0 Roth IRA at 90
$0
$0
$1,935,736 Pre-tax IRA at 90
$0
$858,374 2,350,132
Outside savings at 90
Savings IRA
N/A Conversion tax paid
from
Roth Roth
Pre-tax IRA type
Curly Mo
Larry
Retired couple; Pre-tax IRA;
Main example
John and Mary, married couple
Both age 65, retired
Social security = $20,000/year
Taxable investments = $220,000
Pre-tax IRA = $200,000
File joint return with standard deduction (2008 rates)
Living expenses = $61,200/year + taxes
Earnings rate = 10%
Retired couple; Pre-tax IRA;
Main example
Withdraw $25,000/year from IRA
$5,800 total taxes (all sources)
$19,200 for remaining living expenses
($20,000 S.S. + $22,000 inv. earnings + $19,200 IRA
= $61,200 needed to live)
Result: IRA is empty at age 81
Outside savings carries until just before
age 90
Retired couple; Roth IRA
Conversion
Same facts as previous example except convert to Roth IRA and pay taxes over 2 years from outside savings
Taxes on conversion are $51,000
Continue drawing $22,000/yr from savings even though exceeds earnings
Annual income taxes are much less
IRA distributions aren’t taxable
Neither is social security
Results
Outside savings depleted at 83
At that point, start drawing $41,200 from Roth IRA
Roth IRA lasts to age 94
After-Death Options
Beneficiaries can convert inherited pre-
tax IRA to Roth IRA
Beneficiaries can rollover inherited pre-
tax qualified plan to inherited Roth IRA
RMDs from inherited Roth IRAs same as
RMD from inherited pre-tax IRAs –
based on beneficiary’s life expectancy
Beneficiary Example
Assumptions
Ben converts $100,000 pre-tax IRA to Roth IRA at age 65
8% annual return before 65 and 6% after
Combined tax rate of 27.75%
Ben takes no IRA distributions and dies at age 85
Ben’s 55 year old son, Jerry, is beneficiary
Jerry receives RMDs only
Beneficiary Example
Results
510,964 1,086,191
0 1,086,191
85
482,105 1,048,933
244,452 804,481
80
426,990 941,816
413,498 528,318
75
360,776 804,696
475,564 329,132
70
$296,619
$660,671
$477,225
$183,446 65
Advantage over Tradition IRA Total Roth
IRA Benefit Remaining
balanceIRA Total Tax-
free RMDs Jerry’s
Age
