Tuesday, December 24

Consider a Roth IRA for tax-free income

Tax-free money: It's a dream of every investor. And that's what the Roth IRA can deliver. The downside, of course, is that you must pay Uncle Sam income taxes on the amount you put into a Roth account, whether you contribute directly or convert a traditional IRA. Still, adding a Roth to your nest egg is worth a close look.

The benefits are big, starting with compounded tax-free growth. You can generally withdraw the money during retirement without having to pay income tax. And Roth IRA owners never have to take required minimum distributions, as you must starting at 70 1/2 with traditional accounts. Even for older investors, "Roth IRAs have a very viable place in a financial plan," says Ken Moraif, a certified financial planner at wealth-management firm Money Matters, in Plano, Texas.

One advantage for older investors: By converting part of your traditional IRA to a Roth, you can reduce the size of required minimum distributions from your traditional IRA. You could be in the 15 percent bracket now, but if you have a large traditional IRA, you could end up in the 28 percent bracket when you're required to take withdrawals, Moraif says.

Also, because you never need to take RMDs, a Roth IRA could be the ideal place to hold the aggressive investments of your portfolio, says Christine Fahlund, senior financial planner for T. Rowe Price. These investments, such as growth stocks, can grow tax free, unencumbered by withdrawals.

Moreover, the pot of tax-free money provides flexibility when it comes to your annual tax bill. You can draw on this tax-free income stream if you are in danger of exceeding income thresholds that will trigger certain taxes or that will disqualify you from taking certain tax credits or deductions. For example, instead of having 85 percent of your Social Security benefits taxed, you could perhaps lower the percentage to 70 percent by taking some of your income from a Roth, says Fahlund.

Also, a Roth IRA could be a good source of money to cover a major unexpected expense. If you need $15,000 to replace your roof, that withdrawal from a tax-deferred account could push you into a higher tax bracket. "You have a place to go get extra money," Fahlund says.

Kiplinger's Retirement Report reader Margaret Kearney, 71, and her husband, Bill, 72, who live in Lake View, N.Y., have been doing small Roth conversions for a number of years. By spreading out the conversions, they've kept their tax bills reasonable. Kearney says a big attraction of the Roth is the amount of control the couple can have over the money. "You decide when to let it grow, when to take a distribution and at what price and for what reason," says Kearney. "If we have large expenses, we have Roth assets to tap without being additionally stung by a big tax bite."

No matter how old you are, a conversion could make sense. But many experts say it's best to convert money that you don't plan to use until later in retirement or that you never expect to spend. This gives the money time to grow tax free. "As a rule of thumb, the longer you can defer withdrawals, the greater the benefit," says Ken Hevert, vice-president of personal and small business retirement products at Fidelity Investments.

You can set up a Roth by converting a traditional IRA or by making after-tax contributions to a Roth IRA. Many employers now offer Roth 401k accounts. You can convert all or part of your regular 401k to a Roth or make contributions to it, or both.

The Roth rules are complex. The following answers the essential questions about adding a Roth account to your nest egg.

How much can I contribute each year to a Roth? You must have earned income to be able to contribute to a Roth IRA, but you can contribute at any age (the cutoff is 70 1/2 for traditional IRAs). If you are 50 or older, you can contribute up to $6,500 for 2013 and 2014. However, you cannot make contributions if your income exceeds certain limits. For 2013, the eligibility to contribute to a Roth IRA phases out at $188,000 for married filers and $127,000 for singles ($191,000 and $129,000, respectively, for 2014).

If your company offers a Roth 401k, you can contribute up to $23,000 for 2013 and 2014 if you are 50 or older. Roth 401k contributions for 2013 must be made by December 31, but you have until April 15, 2014, to make 2013 Roth IRA contributions.

If I no longer have earned income, can I still open a Roth? You can, by converting your traditional IRA to a Roth. And unlike contributing to a Roth, there are no income limits for doing a conversion. However, the money you convert will be added to your taxable income for the year, and you will owe income tax at your ordinary rate. To count for 2013, you must convert traditional IRA money by December 31.

You don't have to convert your entire IRA. By converting smaller amounts over several years, as the Kearneys did, you will keep the tax bill smaller. Say you have a $100,000 IRA and you'd like to convert $50,000. You might convert $10,000 a year for five years.

One strategy is to convert enough money to take you up to the top of your current tax bracket. A married couple in the 15 percent tax bracket in 2013 with $39,500 of taxable income could generate another $33,000 of taxable income before hitting the next bracket of 25 percent. "Try to use up lower tax brackets," says Mike Piershale, president of Piershale Financial Group, in Crystal Lake, Ill. "It's a lot cheaper to do a conversion at the 15 percent tax bracket."

Besides pushing you into a higher tax bracket, a large conversion could trigger taxes that are imposed when adjusted gross income exceeds certain thresholds, such as taxes on Social Security benefits. You also could find yourself above the AGI threshold that triggers the new 3.8 percent surtax on investment income. And if your AGI spikes, you could end up paying premium surcharges for Medicare Part B and Part D. Those surcharges will only last a year, though, if your income drops in the year after you convert.

How do I decide if I should do a Roth IRA conversion? Your projected tax rate is the key for deciding whether a Roth conversion might make sense. If you expect your tax rate to be higher in the future, paying the tax on traditional IRA money now at a lower tax rate can be beneficial, says Paul Jacobs, chief investment officer in the Atlanta office of Palisades Hudson Financial Group.

A taxpayer who expects to remain in the same tax bracket can also benefit from a conversion. The tax would be the same whether it's paid now or later. And the conversion will create a pot of tax-free income.

Those who expect their tax rate to be lower in future years should wait to convert. Say you are in the 25 percent tax bracket now, but you will drop to the 15 percent bracket when you retire in a couple of years. Convert now, and "you would lose 25 cents on the dollar instead of 15 cents on the dollar," Piershale says.

Before deciding to convert, make sure you have money outside the traditional IRA to pay the tax bill. Otherwise, you'll be creating another tax bill if you withdraw the tax money from the IRA.

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