More About the Elusive Roth IRA Advantage

In addition to the concerns expressed in “Timing the Roth IRA Conversion” ( JofA, July99, page 73) and “Roth IRAs: Converting, Recharacterizing and Reconverting” (JofA, Aug.99, page 75), readers should consider the following:

When all things—time, amounts, tax and interest rates—are the same, the future value should be the same whether you use a regular IRA (defer taxes now) or a Roth IRA (no tax deferral, but no taxes later on the earnings.)

The advantages of a regular IRA are

• The ability to defer or save taxes now—taxes that may never have to be paid. At the 28% tax rate, the cash cost of a $2,000 contribution is $1,440. The tax saved now may be at a greater rate than the tax finally paid. Under some circumstances, there may even be no tax at all, such as with a charitable beneficiary or when the beneficiary is a no-income or low-income child or senior citizen.
• Considerable tax planning flexibility and potential savings through rollovers to a Roth IRA (with resulting taxable income) that can be timed to offset low income or loss years. This may prevent loss carrybacks and carryforwards from wasting prior and future years’ deductions and exemptions.

The Roth IRA advantages are that

• You can contribute to it after age 70 1/2, and the contributions are not affected by pension plan participation. Use a Roth for the excess whenever the allowed regular IRA deduction is less than $2,000 (or the amount of your earned income).
• A large rollover to a Roth IRA may be used to reduce future required IRA annual distributions, thereby preventing them from causing Social Security income to be taxed.
• The tax paid on conversion to a Roth IRA from a regular IRA reduces the taxable estate. If there is an estate tax, it is desirable to roll over to a Roth IRA in one’s later years. This makes the beneficiary’s IRA distributions nontaxable. Generally, this should not be done unless the beneficiary is going to be taxed.
• A conversion to Roth is a taxable event, thereby reducing future non-IRA investments or increasing debt. This could cause less taxable interest income or greater deductible interest expense in the future, resulting in lower income taxes. These lower taxes could be considered with the future value of the Roth, giving the Roth a greater combined value than the regular IRA.

However, the advantage of a Roth IRA could be reduced or eliminated by future tax rate reductions or other changes, such as introduction of a flat tax. The advantage also could change if funds to pay the tax on the conversion come from the sale of an asset that produces tax-free interest, such as municipal bonds, or if the funds are borrowed (loan interest would not be deductible).

In summary, taxpayers should make the maximum allowable deductible contribution to a regular IRA, with any excess contributed to a Roth IRA. Regular IRAs should be converted to Roth IRAs whenever additional income is needed to avoid wasting the effect on taxes of losses, deductions, exemptions or lower tax rates. Taxpayers also should convert to a Roth IRA to reduce estate taxes if the beneficiary will be taxed on the IRA distributions or convert if required taxable IRA distributions cause Social Security income to be taxed.

Victor G. Trivett, CPA
Miami, Florida