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Ten Roth IRA Myths
by John D. Bledsoe
(c) 1998, John D. Bledsoe
permission for reprint from John D. Bledsoe, 1998
This month we
have a special guest author, John D. Bledsoe. In addition to the
enclosed article, John also wrote an excellent book Roth to Riches:
The Ordinary to Roth IRA Handbook available at major bookstores
and at http://www.amazon.com.
John, like me, is a strong proponent of Roth IRA conversions. Though
I consider John to be a true expert on Roth IRAs, naturally there
are some areas of his article where I have important qualifying
remarks to add. My comments will appear as follows [Jim's comment......].
**Introduction**
I have seen
so many articles concerning Roth IRAs in both the general and financial
press that have been filled with errors, inaccuracies, incorrect
innuendo and just downright bad advice. I have also received many
phone calls from people who discussed Roth IRAs with
their stockbroker, butcher, banker, accountant, neighbor, the clerk
at their brokerage house or some other Roth "expert" who
had given them some misinformation. I would like to take this opportunity
to clear the air on the most prevalent misconceptions about Roth
IRAs.
Myth number 1...
"You cannot use the money converted to a Roth IRA for five
years without additional taxes and penalties."
Wrong.
You may use
up to 100% of the amount transferred or contributed to a Roth even
the day after you convert without any additional taxes (and no penalties
if you are over 59 1/2). The reason for this is that Roth IRAs use
a very favorable accounting method called FIFO. That stands for
first in first out. What this means is that any withdrawals from
a Roth will first be considered from the principal or basis, which
is tax-free. After 100% of the amount of your transfers or contributions
have been withdrawn then taxes or penalties may apply, but then
only if the five-year rule has not been met. People who are under
59 1/2 will still be subject to the old 10% early withdrawal penalty
on converted Roth IRAs. This is exactly as it was before these people
under 59 1/2 converted to a Roth. So to those of you under age 59
1/2,
and who have complained about this, I say GROW UP!
Myth Number 2...
"It takes years for the Roth conversion to catch up and exceed
my regular IRA or IRA rollover."
Wrong.
Many people
who convert from a regular IRA to a Roth IRA have more spendable
(after tax) money from the very first day that they convert. If
the conversion temporarily pushes you into a higher tax bracket,
you may have less spendable money for a time (typically a
very short time). This amount of excess spendable money created
by the Roth conversion then usually grows even greater over time.
No pain no gain clearly does not apply to the Roth IRA conversion.
Myth Number 3...
"Roth conversions are for the young."
Wrong.
Due to the mandatory
distribution rules of regular IRAs and retirement plans the Roth
may even have a greater advantage for those age 70 and over who
convert to a Roth. Younger people will still have great benefits
by the Roth conversion and they may have much longer periods to
accumulate money on a tax free vs. tax deferred basis.
Myth Number 4...
"My income tax rate will be lower when I retire."
Maybe not.
Most of the
clients that I have had through the years thought that this would
be the case. However, for almost all of them, the older they get,
even through retirement, the higher their income tax bracket.
Myth Number
5...
"My regular IRA is my money and it is worth what the brokerage
statement says that it's worth."
Wrong.
The IRA or
rollover account is always worth less than the account statement
says that it is. This is because you have a partner in the IRA on
every penny...called the IRS.
Myth Number 6...
"My spouse and I can pass to our children $1,250,000 without
any estate tax."
Not always.
If an IRA is
a substantial part of your assets it is often needed to fund the
(currently) $625,000 bypass trust created at the first death. In
a very high percentage of the cases the IRA cannot be placed into
this bypass trust. If the non-IRA holder spouse dies first the IRA
may not even be considered as an asset of the bypass trust. Even
if the IRA is available for this bypass trust it is often not utilized
due to the adverse income tax consequences of holding the IRA in
trust. Bottom line what this means is that many people who are married
with their IRAs representing their main asset, will only have the
one estate tax exclusion of $625,000.
[Jim's comment...
The "adverse income tax consequences of holding the IRA in
trust" are often not nearly as severe as paying a 50% estate
tax. Furthermore, with proper estate planning, there are ways to
use an IRA asset to fund a decedent's credit shelter amount. For
example, in our practice, we utilize a very specific type of bypass
trust as the contingent beneficiary of a decendent's IRA or pension
account. (The spouse is usually named the primary beneficiary of
the IRA. At the death of the first spouse, the survivor can choose
to voluntarily disclaim an amount necessary to fund the bypass trust).
This "disclaimer" approach to estate and retirement planning
can often avoid or mitigate the estate tax problems accurately identified
by John in his article.]
Myth Number 7...
"My income is too high to qualify for the IRA conversion."
Maybe not.
It is true that
your modified adjusted gross income has to be $100,000 or less in
the one year that you convert to a Roth IRA. However, many of my
clients with substantially higher incomes have met this qualification
with careful income tax planning. Remember this $100,000 limitation
only applies to the conversion year. Even if you cannot qualify
for a 1998 Roth conversion, converting in a later year will still
be a great advantage for most people even without the benefit of
the special 1998 4-year conversion tax deferral.
Myth Number 8...
"The Roth conversion will not be advantageous to most people,
and for the few people that it would help, it really only benefits
their heirs."
Wrong.
There are two
main categories of people who can benefit from the Roth conversion.
The first type is anyone over age 59 1/2. The second type is anyone
else who has funds outside their IRA with which to pay the taxes
upon conversion. These two categories comprise a large number of
the folks who have regular IRAs. Additionally the benefit is to
the person who converts, as they are able to enjoy more in after
tax spendable income for the rest of their lives. To the extent
that there is money left over at death then the Roth conversion
further benefits their heirs.
Myth Number 9...
"The IRA can be deferred for a long time after I turn age 70
1/2, and when I die my spouse or heirs will be able to continue
this deferral for a long time in the future."
Not likely.
Most IRA holders
desire this so-called "stretch out", or maximum deferral
strategy for their IRAs. However, the mandatory taxable withdrawals
are in reality much faster than desired. This is often due to the
first death occurring later than anticipated as well as the "wrong
spouse" (non-IRA holder) often dying first. Keep in mind that
Roth IRAs have no mandatory lifetime withdrawals as well as no elections
(irrevocable or otherwise) that must be made at 701/2. As a result
if maximum income tax deferral is your desire, then the Roth is
a much better vehicle.
[Jim's comment...The
IRA distribution rules after death are basically the same between
regular and Roth IRAs (except a surviving spouse would also enjoy
no mandatory lifetime distributions). The difference becomes how
the distributions are taxed. Even if you can't or don't convert,
make sure you understand all the ways to mitigate the minimum distribution
requirements. Also, make sure your heirs learn about the election
they will have to make after you are gone regarding the "stretch
out".]
Myth Number 10...
"My congresswoman or favorite presidential candidate has assured
me that a flat tax is near, and this flat tax rate will be so low
that the Roth conversion will have no significant advantage."
Don't tell me that you
fell for that one!
The majority
of political pundits do not believe that a flat tax is in our future.
Even if we were to have a flat tax, the flat tax rate would have
to be so unrealistically low (17% or so), for the Roth conversion
to have been a mistake.
[Jim's comment...Even
if Congress passed a 17% flat tax, for current 28% tax bracket IRA
owners the Roth IRA conversion would still be advantageous if the
investment period is 8 years or more. If we are going to be afraid
of remote taxes that will make the Roth IRA
unfavorable, I am more afraid of a switch to a national sales tax.
I think, however, that even if Congress did pass a sales tax, they
would still want to tax all the billions of dollars in IRAs and
retirement plans in which owners always expected to pay tax.]
Summary
The conversion of an ordinary IRA to a Roth will be very beneficial
to many people. Before you dismiss the Roth IRA as a bad idea or
convert your IRA to a Roth, you really must run the numbers on your
specific situation. I suggest that you consult a true Roth IRA expert
on this very important decision.
Author:
John D. Bledsoe
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