1/29/2014 7:45 PM ET|
Considering a Roth IRA? Check state taxes first
If you live in a high-tax state such as New York but plan to retire to an income-tax haven like Florida, a Roth IRA may not make sense.
Just about every article I've read on Roth IRA conversions discusses their benefits for people who might be in a high tax bracket once they retire.
What these articles invariably fail to mention is the negative impact that state income taxes could have and why, depending on where you plan to live, a Roth conversion might actually not be the best decision for everyone.
When you convert a 401k plan account or traditional IRA to a Roth IRA, you're making the conscious decision to pay income taxes today for the promise of a tax-free income tomorrow. This can be a wise choice if you are fairly confident that a) you'll be in a higher tax bracket during retirement, and b) Congress won't dramatically change the tax rules on Roth IRA withdrawals.
Those with high incomes who are saving and investing successfully—and who believe they'll continue to have a high income once they retire—seem prone to a certain line of reasoning: Because the promise of tax-free income from a Roth IRA is so appealing, why not just take some retirement savings today, pay the tax at current levels and then sit back and enjoy tax-free income during retirement? After all, just about "everyone" thinks that taxes will be higher in the future, right?
But converting money from a 401k or IRA to a Roth IRA triggers not only federal income taxes but also taxable income in the state in which you currently reside. While there are seven states -- Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming -- with no state income tax, many others have prohibitively high rates.
The top income-tax rate in New York, for example, is around 9 percent, while California's top rate is north of 13 percent.
If you reside in a state with high income-tax rates and convert money to a Roth IRA, you'll not only be forced to pay Uncle Sam, you'll also find yourself writing a check for thousands of dollars to help fund your state government.
This is obviously one reason so many people, once retired, flee high tax-burden states for states with lower taxation rates.
You must consider that because retirement withdrawals are taxed based on the rates of the state in which you reside when you actually take those withdrawals, a traditional 401k or IRA withdrawal will be state tax–free if you live in a state with no income tax. Again, it makes no difference if the withdrawal is coming from a traditional IRA or a Roth IRA -- the withdrawals are taxed the same (0 percent) in places with no state income tax.
If you plan on moving out of your current high-taxed state to retire in a location with no state income tax, why would you want to convert anything to a Roth IRA? By doing so, you would be taking money that would be state income tax–free during retirement and making those dollars taxable today.
Simply put: If your current primary residence has high state income taxes, you could be forking over a considerable amount of money today for absolutely zero benefit during your golden years.
There are some circumstances where a Roth conversion still might make sense, such as during a period of prolonged unemployment, but for those who are confident they'll be leaving their state when they retire, a Roth conversion is simply a bad idea the vast majority of the time.
This same logic applies to contributions to Roth 401k plans. Again, using the traditional plans may have greater benefit if you leave your high-taxed state once you retire.
More from CNBC
VIDEO ON MSN MONEY
it's not only how much money you put in that matters with Roth IRA's, absolutely ALL profits gained within your investment period are also TAX FREE! So say your ROTH IRA portfolio gains $100k over the life of your account, that's 100% tax free $$$
1) First and foremost, there is the "Age-Out"/Required Minimum Distribution aspect - at age 70-1/2, regardless of what else is going on, anyone having a "traditional" IRA and/or 401 account: a) Must begin - per Federal regulations - receiving/withdrawing a Required Minimum Distribution from each and every such account, every year, with the amount that must be taken out determined by the Fed, based upon their age and their "actuarily-determined remaining lifespan", and must therefore pay taxes on the RMD(s) every year - there is NO CHOICE involved, and the penalties for failing to do this are substantial; also (and this is the REAL stinger!) b) At the same time, you may NO LONGER make deposits/contributions - other than POSSIBLY by rollover from one account to another - to either a self-administered pre-tax IRA OR a 401k plan - you've "aged-out". Understand - this is the FedGov FORCING older pre-tax account holders to "cash in", gradually - so the Fed can collect taxes on most or all of your pre-tax retirement investments BEFORE you're likely to croak - AND mostly locking you out of further deposits to said accounts.
As currently constituted - and likely to remain for some time to come -, Roth accounts have no such RMD requirement, AND Roth account-holders are free to continue making deposits and therefore "growing" their accounts.
Second thing the writer neglected to take into account is less important but also a consideration - since, by its nature, you have much more control over the taxation and investment/deposit aspects of a Roth account, if for some reason you need to control total taxable income in a given year you're much better off.
In addition, some States - such as Florida - that are currently State income-tax-free will, when they need additional "revenue", sooner or later (and perhaps sooner?) start to reconsider possible State income taxes. There's no requirement - at any level - that they continue as at present.
As others here point out, there are some other aspects to consider - but, on balance, the Roth plans make a better deal all-around.
Who wrote this advertisement (er article), the Real Estate Association of Florida?
Seriously, I converted my Rollover IRA to a Roth in 2010. I have since seen its value grow 58%; all tax free gains that I would have otherwise had to pay taxes on. Add to this the benefits of Roth IRA’s that other commenters have mentioned and I estimate my Roth IRA will be worth at least 50% more than a traditional IRA on an after-tax basis after 30 years.
Almost everyone I know who has a traditional IRA, 401k, or other form of tax deferred investment has found themselves in a tax trap as a result. I tell every young person who is starting to save for retirement to go with a Roth from day one.
It’s sad isn't it, how neither the government nor Wall Street can stand to see of you holding and saving money without them being able taking a piece of it from you.
Copyright © 2014 Microsoft. All rights reserved.