The U.S. budget compromise reached at the start of the year included a few significant changes for retirement plans. The most important is a provision that will encourage Americans, who hold some $3 trillion in retirement accounts, to make a big shift in their savings plans and roll their savings into a Roth account to avoid the specter of higher tax rates at retirement.
The Roth is now open to anyone who has a 401(k) and works for an employer that offers a conversion plan. This extends the benefit to far more people because it eliminates income caps for higher earners who can benefit most. Because it is a workplace plan, it can only be set up through the 401(k), and only about half of plans offer the option now, though the number is growing quickly.
As a result, Roth plans have been opened for many more wealthy people than in the past. For Roth plan providers and wealth managers, it promises a wave of new rollovers, and they are already stepping up their marketing campaigns to sign you up. But some retirement experts are skeptical about whether investors should be rolling their savings from 401(k) plans into Roth accounts.
While new Roth savers must pay a big tax on previously untaxed IRAs, making the switch provides tax-free withdrawals that are particularly attractive to upper-income earners who know they will remain in a high tax bracket after they retire. In the past, income caps have limited their access.
As such, Roths will attract tax-phobic investors at a time when many fear that the $16 trillion national debt will cause tax increases far into the future. Eliminating future taxes on retirement funds is the main selling point for Roths. Some advisers say the choice comes down to a single question: Do you think taxes will rise? If you do, you should pay taxes now at a lower rate.
But that is an oversimplification, says Jean Setzfand, vice president for financial security at AARP. While a compelling case can be made for a Roth rollover for some people, the cost-benefit is hard to clearly demonstrate for many others.
"The way I think about it, the future is in the unknown bracket for most of us, as far as future tax rates and bills. It's not a clear-cut decision in my mind," she says. "The macroeconomic issues are out of your control, and you can never be sure about your own job and future."
Another simple Roth-related question advisers ask: "Do you want to pay taxes now or later on in retirement when you have less money?" In this economy, people struggling to get by are discouraged about their future, and the reaction might be that retirement may be off the table altogether, or a less-pressing concern than avoiding any extra expense today.
No silver bullet for deciding conversions. But retirement experts say it's not good science to make retirement plans based on either fear or denial. The chances of a grim, tax-crazed future are not as high as some might think. But ignoring the future impact of taxes in retirement will not fix the problem either, and most people will be in retirement for a long time.
"You can't just hunker down and say, 'I'll just put some away some fixed income and forget about it,'" says Billy Lanter, fiduciary investment advisor at Unified Trust in Lexington, Ky. "This is where the longevity issue comes in. You need to plan for the long-term horizon for living another 25 years or more after retirement."
The people for whom Roths make the most sense are those who have a realistic expectation that they will be making enough money at retirement age to create a significant tax bill. There is no clear cutoff or formula about income levels or life expectancy, although many calculators let you explore various scenarios.
"There is no silver bullet and no perfect answer. It comes down to each special tax situation and stage of life a person is in," says Lanter.
One rule does hold for everyone, he says. People should never raid tax-protected IRAs to pay the tax required to do a conversion. Those funds built up over time are the hardest to replace. "If you have to pay the tax liability from nontaxable funds, you lose 100 percent of the time," Lanter says.
There is also widespread agreement that younger people are good candidates for a Roth as they start their careers. They can forego pre-tax contributions afforded by the traditional IRA while their tax burden is relatively light. As they do so, they will be investing in assets that will grow tax-free for all of their working years and they can keep 100 percent of the funds when they withdraw them in retirement.
"For them, it's really a no-brainer," says accountant and retirement adviser Ed Slott, of Ed Slott and Co.
The Roth plans also are not limited by minimum withdrawal requirements, adding flexibility that traditional IRAs lack. Some financial advisers see this as a way to protect income that people wish to pass along to heirs.
Long-term Roth advantage versus short-term cost. The choice of a Roth or a traditional IRA could also dictate the way you invest, says Slott. "Once you are in a Roth, you might tend to make more aggressive investments that accumulate capital gains that are all tax-free without required withdrawals, and that changes your risk profile."
To be sure, the Roth adds a level of complexity to financial planning at a time when people are already confused by retirement options. AARP's Setzfand says that in some cases, a financial adviser will be needed to sort things out. Lanter agrees that some of the strategies for creating a diversified income source require a specialist view owing to the new batch of related rules and options. People with the cash to set up a Roth "usually have the money to do that," says Setzfand. But individuals can decide their own strategy for putting funds in one or both, she adds.
"I love the diversity this [expanded Roth] offers," says Setzfand. "You can set it up so you have a mix of income in retirement that is taxable and tax-free, and some that is not subject to required withdrawal rules. Just like with investments, it's always good to diversify."