Introduction

I have seen so many articles concerning Roth IRAs in both the general and financial press that have been filled with errors, inaccuracies, incorrect innuendo and just downright bad advice. I have also received many phone calls from people who discussed Roth IRAs with their stockbroker, butcher, banker, accountant, neighbor, the clerk at their brokerage house or some other Roth "expert" who had given them some misinformation. I would like to take this opportunity to clear the air on the most prevalent misconceptions about Roth IRAs.

Myth number 1…

Wrong.

You may use up to 100% of the amount transferred or contributed to a Roth even the day after you convert without any additional taxes (and no penalties if you are over 59½). The reason for this is that Roth IRAs use a very favorable accounting method called FIFO. That stands for first in first out. What this means is that any withdrawals from a Roth will first be considered from the principal or basis, which is tax-free. After 100% of the amount of your transfers or contributions have been withdrawn then taxes or penalties may apply, but then only if the five-year rule has not been met. People who are under 59½ will still be subject to the old 10% early withdrawal penalty on converted Roth IRAs. This is exactly as it was before these people under 59½ converted to a Roth. So to those of you under age 59½, and who have complained about this, I say GROW UP!

Myth Number 2…

Wrong.

Many people who convert from a regular IRA to a Roth IRA have more spendable (after tax) money from the very first day that they convert. If the conversion temporarily pushes you into a higher tax bracket, you may have less spendable money for a time (typically a very short time). This amount of excess spendable money created by the Roth conversion then usually grows even greater over time. No pain no gain clearly does not apply to the Roth IRA conversion.

Myth Number 3…

Wrong.

Due to the mandatory distribution rules of regular IRAs and retirement plans the Roth may even have a greater advantage for those age 70 and over who convert to a Roth. Younger people will still have great benefits by the Roth conversion and they may have much longer periods to accumulate money on a tax free vs. tax deferred basis.

Myth Number 4…

Maybe not.

Most of the clients that I have had through the years thought that this would be the case. However, for almost all of them, the older they get, even through retirement, the higher their income tax bracket.

Myth Number 5…

Wrong.

The IRA or rollover account is always worth less than the account statement says that it is. This is because you have a partner in the IRA on every penny…called the IRS.

Myth Number 6…

Not always.

If an IRA is a substantial part of your assets it is often needed to fund the (currently) $625,000 bypass trust created at the first death. In a very high percentage of the cases the IRA cannot be placed into this bypass trust. If the non-IRA holder spouse dies first the IRA may not even be considered as an asset of the bypass trust. Even if the IRA is available for this bypass trust it is often not utilized due to the adverse income tax consequences of holding the IRA in trust. Bottom line what this means is that many people who are married with their IRAs representing their main asset, will only have the one estate tax exclusion of $625,000.

[Jim’s comment: The "adverse income tax consequences of holding the IRA in trust" are often not nearly as severe as paying an estate tax over 50%. Furthermore, with proper estate planning, there are ways to use an IRA asset to fund a decedent’s credit shelter amount. For example, in our practice, we utilize a very specific type of bypass trust as the contingent beneficiary of a decendent’s IRA or pension account (with the spouse as the primary beneficiary who can choose to voluntarily disclaim that amount necessary to fund the bypass trust). This "disclaimer" approach to estate and retirement planning can often avoid or mitigate the estate tax problems accurately identified by John in his article.]

Myth Number 7…

Maybe not.

It is true that your modified adjusted gross income has to be $100,000 or less in the one year that you convert to a Roth IRA. However, many of my clients with substantially higher incomes have met this qualification with careful income tax planning. Remember this $100,000 limitation only applies to the conversion year. Even if you cannot qualify for a 1998 Roth conversion, converting in a later year will still be a great advantage for most people even without the benefit of the special 1998 4-year conversion tax deferral.

Myth Number 8…

Wrong.

There are two main categories of people who can benefit from the Roth conversion. The first type is anyone over age 59½. The second type is anyone else who has funds outside their IRA with which to pay the taxes upon conversion. These two categories comprise a large number of the folks who have regular IRAs. Additionally the benefit is to the person who converts, as they are able to enjoy more in after tax spendable income for the rest of their lives. To the extent that there is money left over at death then the Roth conversion further benefits their heirs.

Myth Number 9…

Not likely.

Most IRA holders desire this so-called "stretch out", or maximum deferral strategy for their IRAs. However, the mandatory taxable withdrawals are in reality much faster than desired. This is often due to the first death occurring later than anticipated as well as the "wrong spouse" (non-IRA holder) often dying first. Keep in mind that Roth IRAs have no mandatory lifetime withdrawals as well as no elections (irrevocable or otherwise) that must be made at 70½. As a result if maximum income tax deferral is your desire, then the Roth is a much better vehicle.

[Jim’s comment…The IRA distribution rules after death are basically the same between regular and Roth IRAs (except a surviving spouse would also enjoy no mandatory lifetime distributions). The difference becomes how the distributions are taxed. Even if you can’t or don’t convert, make sure you understand all the ways to mitigate the minimum distribution requirements. Also, make sure your heirs learn about the election they will have to make after you are gone regarding the "stretch out".]

Myth Number 10…

Don’t tell me that you fell for that one!

The majority of political pundits do not believe that a flat tax is in our future. Even if we were to have a flat tax, the flat tax rate would have to be so unrealistically low (17% or so), for the Roth conversion to have been a mistake.

[Jim’s comment…Even if Congress passed a 17% flat tax, for current 28% tax bracket IRA owners the Roth IRA conversion would still be advantageous if the investment period is 8 years or more. If we are going to be afraid of remote taxes that will make the Roth IRA unfavorable, I am more afraid of a switch to a national sales tax. I think, however, that even if Congress did pass a sales tax, they would still want to tax all the billions of dollars in IRAs and retirement plans in which owners always expected to pay tax.]

Summary

The conversion of an ordinary IRA to a Roth will be very beneficial to many people. Before you dismiss the Roth IRA as a bad idea or convert your IRA to a Roth, you really must run the numbers on your specific situation. I suggest that you consult a true Roth IRA expert on this very important decision.

[Jim’s comment…Like this article, John’s book, Roth to Riches: The Ordinary to Roth IRA Handbook, has excellent content and is quite well written. If you qualify for a significant Roth IRA conversion, the $20 you will spend on his book is well worth it. Of course, with or without reading the book, if you do qualify for a significant Roth IRA conversion, I would implore you to meet with a expert in this area.]

James Lange is a tax attorney and CPA with a thriving retirement and estate planning practice in Pittsburgh, Pennsylvania.  He focuses on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, will and trust preparation, and intricate beneficiary designations for IRAs and other retirement plans.  Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, and his articles are frequently published in Financial Planning, Kiplinger's Retirement Report and The Tax Adviser.