Now that anyone who has a retirement account has the ability to open a Roth IRA, some investors who were previously locked out of Roths due to income restrictions have jumped at the chance for a lifetime of tax-free growth. Others, though, are still weighing whether converting to a Roth really makes sense for them.
As I wrote about yesterday, one of the most common reasons why a Roth conversion might not be the best move is if you believe your tax rate will drop by the time you need to start taking money out of your retirement accounts. But that's not the only reason. Today, let's take a look at another concern: whether older investors whose time horizons are shorter than younger investors' get enough out of a Roth to justify converting.
The benefit of time
Many see Roth IRAs as a perfect investment vehicle for younger people, and with good reason. Those who are just starting out benefit in a number of ways from using Roth IRAs:
- They'll get the benefit of not having to pay taxes on investment income and capital gains for the longest possible time.
- Typically, they earn less than those who are further along in their careers, meaning that they're typically in lower tax brackets. That in turn reduces the tax cost of converting.
- Roth IRAs make it easier to take out at least part of your money before retirement if you need it for other purposes. With common expenses like making a down payment on a home creating major challenges for young people, withdrawing Roth contributions on a tax-free, penalty-free basis might not be ideal, but it's better than paying penalties to get at a traditional IRA.
On the other hand, older investors may not get much from these advantages. With only a limited time left before retirement, they may not benefit as long from tax-free treatment. Those who haven't yet retired may be at their maximum earning potential, therefore paying the most in taxes that they ever will. And once you reach age 59 1/2, you're old enough to take out IRA money penalty-free for whatever purpose you want.
The worst thing that can happen
Another concern among those with short time horizons is that if the markets move against you, converting a Roth at the wrong time can cost you much more in taxes than you would have paid in a traditional IRA. And the shorter your time horizon is, the more likely it is that you won't be able to wait out a market downturn.
The past 10 years offer a perfect example. Let's look at someone in a similar situation to yesterday's example, but who owns a different set of stocks. Assume you had $10,000 invested in each of the following seven stocks back in 2000:
|
Stock |
Total Return Since 2000 |
$10,000 Invested in 2000 Is Now Worth |
|---|---|---|
|
Walt Disney |
(11.3%) |
$8,870 |
|
Verizon |
(17.0%) |
$8,300 |
|
Merck |
(22.2%) |
$7,780 |
|
General Electric |
(53.7%) |
$4,630 |
|
Texas Instruments |
(55.6%) |
$4,440 |
|
Cisco Systems |
(57.0%) |
$4,300 |
|
Time Warner |
(78.5%) |
$2,150 |
Source: Yahoo! Finance. As of Jan. 26.
Your $70,000 portfolio would now be worth just over $40,000. If you'd converted to a Roth back in 2000, you would have paid taxes on the full $70,000 amount. If you had kept those losing investments in a traditional IRA, however, you'd only pay tax on the $40,000 that was left if you withdrew it all right now. Even if you're in a higher tax bracket now, your total tax bill is likely to be a lot lower now -- and you had 10 extra years before you had to pay it.
Of course, if those losses happen right after you convert, you can simply recharacterize the Roth conversion and start over. But if the losses come after the deadline for recharacterizing passes, then you're stuck. And without a long-enough time horizon to wait out a market decline, older investors can't afford to wait for things to get better.
Weighing the possibilities
On the other hand, Roths have certain advantages for older investors, such as the fact that you don't have to take required minimum distributions as you do with regular IRAs. Yet if you're planning to spend your Roth money anyway, that's not worth as much as it is for those who expect to leave their IRA money to their heirs.
Age is just one among several factors in deciding whether a Roth is right for you. Tomorrow, I'll take a look at another key element in the Roth decision: whether converting to a Roth will force you to give up other valuable tax benefits.
Tune in for the rest of this series on evaluating whether you're better off sticking with your current retirement plan rather than converting to a Roth.
