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Roth Contributions, Roth Conversions: What to Do?

money_treeBy Jim Terwilliger

I often say that the Roth IRA — and more-recent Roth 401(k) — is one of the greatest gifts bestowed by the US Congress on the American taxpayer.

It amazes me that so many folks do not understand its value and, consequently, do not employ it as part of their retirement savings plan.

When should the Roth be used? Like most other financial questions, it depends.

One rule of thumb suggests that putting money aside in a Roth-type account only makes sense when one expects his/her future marginal income tax rate to be higher than current. But this advice generally is paired with the option to put the money aside, instead, in a traditional IRA/401(k). This either-or exercise does not consider the Roth as an attractive stand-alone option.

Another challenge to this rule is uncertainty around future income tax rates. The current political landscape leaves most of us clueless as to what marginal tax bracket we might find ourselves in 10, 20, 30 years out.

A tempting, but dangerous, exercise is to use one of the many Roth conversion calculators found on the Internet. Such calculators spit out exact numbers with a yes-or-no recommendation, giving the results the appearance of ultimate precision. But, change just one or two assump tions and the resulting recommendation can do a “180.”

Setting rules of thumb and the allure of calculators aside, we’ll review the tax advantages of a Roth-type account and consider some of the factors that might lead you to consider Roth vehicles in your retirement plan.

Roth Characteristics

Unlike contributions to a traditional IRA/401(k) plan, Roth contributions are made after-tax. Such investments, once in a Roth account, can grow and are shielded from income taxes forever — as long as certain rules are followed.

Second, contrary to rules for traditional IRAs/401(k)s, required minimum distributions (RMDs) are not required starting at age 70-1/2. Al though this is not the case for Roth 401(k) accounts, once a Roth 401(k) is rolled over to a Roth IRA, RMDs are no longer in the picture.

Additionally, contributions (principal) can always be taken out without tax or penalty. Distributions are considered principal first. However, we do not recommend premature distributions from an account intended to fund retirement.

Roth Contributions

We recommend that folks approaching retirement have a reasonable mix of all three types of accounts — pretax, tax-free (Roth), and taxable. This is known as tax-risk diversification and is something I addressed in detail in a past column. All three have their pros as well as cons. My view is that the pros for Roth accounts far outweigh any cons, making them a critical part of any retirement portfolio.

As long as the income cap is not exceeded, establishing and contributing to a Roth IRA is easy to do. And for those whose employer offers a Roth 401(k), this is an ideal pathway for Roth savings — high contribution limits and no income cap.

Roth Conversions

This is the tricky part. This consideration arises typically after retirement starts. Should I do a wholesale IRA-to-Roth IRA conversion? Should I meter it out over time? Forget the rules of thumb. Forget the conversion calculators. This decision depends on individual circumstances. Here are some real-life examples from our work with clients:

• Wholesale Conversion — Generally, not a good idea, particularly if the IRA balance is large. Negative consequences include a potentially- huge one-year tax hit that could take someone up into the 39.6 percent federal tax bracket, put capital gains into 20 percent territory, trigger the 3.8 percent additional Medicare tax on net investment income (due to increased adjusted gross income), and trigger a high Medicare Part B/D tax in a future year. Additionally, paying resulting large tax bill can put a burden on the account used to fund the tax, resulting in a smaller nest egg left to grow.

This is definitely a no-no if you intend to fund ultimate charitable bequests via IRA beneficiary designations, since disposition of the IRA will then be tax-free.

•Partial Conversions — This can make perfect sense under many circumstances. Examples include: 1) topping off the 15 percent federal tax bracket with strategic annual conversions between retirement and age 70-1/2; 2) converting a portion in a year in which you will have significant business losses or medical deductions; and 3) strategic annual conversions needed to fully soak up a previous significant charitable contribution over the following carryover years.

As always, don’t try to develop optimal Roth strategies, short or longterm, on your own. Be sure to work with a trusted financial professional to help chart your course.

James Terwilliger, CFP, is senior vice president, financial planning manager, Wealth Strategies Group, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext. 50630 or by email at


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