Top Nine Roth IRA Myths
by John D. Bledsoe
© 1998, John D. Bledsoe 

Permission for reprint from John D. Bledsoe, 1998

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 of the most prevalent misconceptions about Roth IRAs.

Myth # 1

"You cannot use the money converted to a Roth IRA for five years without additional taxes and penalties."

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 After 100% of the amount of your transfers or contributions have been withdrawn, then taxes or penalties may apply, but then only if the five-year rule has not been met.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 # 2

"It takes years for the Roth conversion to catch up and exceed my regular IRA or IRA rollover."

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 # 3

"Roth conversions are for the young."

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 # 4

"My income tax rate will be lower when I retire."

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, their income tax bracket rises throughout their retirement.

Myth # 5

"My regular IRA is my money and it is worth what the brokerage statement says that it’s worth." 

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 # 6

"My income is too high to qualify for the IRA conversion." 

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 year 2000 Roth conversion, converting in a later year will still be a great advantage for most people.

Myth # 7

"The Roth conversion will not be advantageous to most people, and for the few people that it would help, it really only benefits their heirs." 

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 # 8

"The IRA can be deferred for a long time after I turn age 70½, and when I die my heirs will be able to continue this deferral for a long time in the future." 

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. 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 for regular and Roth IRAs.  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 # 9

"My congresswoman or favorite presidential candidate has assured me that a flat tax is near, and this flat tax rate will be so low that the Roth conversion will have no significant advantage."

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 will be 8 years or more.  If we are going to be afraid of remote taxes that will make the Roth IRA unfavorable, I would be 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 on which owners have always expected to pay tax.

Summary

The conversion of an ordinary IRA to a Roth IRA 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.

James Lange is a tax attorney and CPA who provides specialized retirement and estate planning services to same sex with significant retirement plan accumulations.  He has prepared over 450 simple and complex retirement and estate plans.  These plans include tax-savvy advice, will and trust preparation, and sophisticated beneficiary designations for IRAs and other retirement plans. You can contact Jim by phone at (800) 387-1129, or (412) 521-2732, or by e-mail at admin@outestateplanning.com.