The Roth IRA

The Roth IRA

By James Hooban

A fifty-five year old friend of mine, Jane, recently changed jobs from her employer of fifteen years for a better opportunity. She had diligently contributed to her company’s 401k programand elected the “pre-tax” contribution option, thereby postponing tax on the saved money, into the future. Between her own contributions and her employer’s match, she stashed away $13,000 on average over her fifteen years which grew to almost $300,000 before she left the company.

She explored her investment options with her tax accountant and investment manager. She decided to convert her 401k plan to a Rollover IRA and then convert the IRA to a Roth Rollover IRA.

She was advised that a 401k plan can be converted to a Rollover IRA without limitation by the IRA rules pertaining to Modified Adjusted Gross Income. She was also advised that Rollovers are not limited by Annual Contribution limits. Armed with that advice, she decided that a Roth Rollover IRA was the right way forward for her. We’ll take a look into the downside and advantages of her decision.

The big downside in the decision is that conversion to a Roth IRA subjects the amount rolled over to tax at your marginal tax rate. In fact, based on her income and the amount of the rollover, Jane’s decision results in draws tax of about 30 percent of her rolled over amount.

In order to protect the benefits of the Roth election, the funds must remain in the Roth IRA account for a minimum of five years from the date of conversion.

So why take those negatives? Here are the advantages to offset that costly downside:

  1. The tax payment can be withheld from the IRA funds being rolled over. This would leave Jane a net Roth IRA savings account of $210,000. The tax payment can also be made from other available funds.
  2. Assuming there is no need to draw the funds until retirement at 65, in this example there are ten years to make up the tax burden from this year.
  3. Over a period of ten years, at a cumulative annual gain of 7.5%, the account would reach over $410,000. The account would reach its original $300,000 level in the same period at a 3.66% cumulative gain. Neither earnings, nor equity gains within Roth IRA will be subject to tax as long as the five year “don’t withdraw” rule is observed.
  4. In the same period, a 401k or Rollover IRA plan would reach $600,000 at 7.5% and $425,000 at 3.66% average annual cumulative gains. If Jane had made one of these choices, every penny of her savings would be subject to tax and rates in force when the money is withdrawn.
  5. A Roth Rollover IRA option has no mandatory withdrawal requirements
  6. Traditional IRA and 401k accounts withdrawal requirements that start at age 70½.

There is a level of flexibility with Roth account balances. After risking investment in equities for higher returns in the ten-year period, Jane could change her investment profile to investments that produce stable and regular earnings, such as bonds or bond funds.

Using the $410,000 account level (item 3 above) and a dividend rate of 4.5%, $1,500 could be withdrawn every month without tax. Roth IRA withdrawals are not counted as income in calculations otherwise used by IRS to determine Adjusted Gross Income or Modified Adjusted Gross Income.

As with all other issues relating to your investments, consult tax and investment professionals who know you and your personal situation before making changes to your investment strategies. The decisions described here might not be right for you, but Jane’s situation might give you something to think about.