As an educator, you have a couple of valuable building blocks for your retirement savings. Your defined benefit pension through CalSTRS or CalPERS forms the foundation. You can create a more solid structure by contributing to your voluntary 403(b) or 457 plan. You may also be taking advantage of a traditional individual retirement account (IRA), another vehicle for tax-advantaged retirement saving.
For more than 35 years, traditional individual retirement accounts (IRAs) have provided tax advantages – including tax deferral and the potential for a tax deduction – to people saving money for retirement.* Roth IRAs were introduced in 1998, offering a different set of advantages, including the potential for tax-free withdrawals. But there were limitations on who could convert a traditional IRA to a Roth IRA. Now, that’s changing.
Q: What’s new?
A: Beginning Jan. 1, 2010, conversions from a traditional IRA to a Roth IRA were no longer limited to taxpayers with a modified adjusted gross income of $100,000 or less, as they were prior to that date. In addition, married couples who file separately are no longer prevented from making a conversion. Now, anyone can convert a traditional IRA to a Roth IRA.
Q: What are the tax consequences of converting to a Roth?
A: You owe ordinary income taxes on all or a portion of the amount converted, depending on whether you made deductible or nondeductible contributions to the traditional IRA. Usually, the tax is due when you file a federal income tax return for that year.
Q: What are some potential advantages of converting a traditional IRA to a Roth IRA?
A: Distributions from a Roth IRA are tax-free if you’re age 59½ or older and have held the account at least five years.** You are not required to begin taking minimum distributions at age 70½, as you are with a traditional IRA. Distributions are not required during the original account holder’s lifetime (but they are required for beneficiaries). And if you leave the account to heirs, your beneficiaries can receive the assets tax-free.
Q: What are some reasons I might not want to make the conversion?
A: Converting may not make sense if you:
- Don’t think you’ll be in the same or a higher tax bracket in retirement. The taxes you pay on the conversion could end up being higher than the taxes you’d pay when making withdrawals from your traditional IRA, if you didn’t convert it.
- Can’t pay the taxes on the conversion from sources other than your IRA. If you’re younger than age 59½, you’ll probably owe a 10% penalty on IRA funds withdrawn to pay taxes. And in any case, you’ll lose the potential benefit of tax-free growth on that amount.
- Don’t have a long enough time horizon to allow a Roth’s tax-free earnings to compensate for the taxes you pay on the conversion.
With so many factors to consider, deciding whether to convert a traditional IRA to a Roth IRA is a complex decision. A financial advisor can help you weigh your options.
* Taxes will be due upon withdrawal at ordinary income tax rates. Premature withdrawals – generally, those made before age 59½ – may be subject to a 10% tax penalty, as well.
** Premature withdrawals – generally those made before age 59½ or within five years of opening the account – may be subject to ordinary income taxes and a 10% tax penalty.
Comparing Traditional and Roth IRAs
| ||Traditional IRA ||Roth IRA |
|Who may contribute? ||Anyone under age 70½ with earned income and their spouses ||Anyone of any age with earned income, up to a maximum modified adjusted gross income (MAGI) of $125,000 a year (single filers) or $183,000 (married filing jointly), and their spouses. Married taxpayers who file separately cannot contribute to a Roth if their MAGI exceeds $10,000.* |
|What is the maximum contribution in 2014?** ||$5,500 or earned income, whichever is less. ||$5,500 or earned income, whichever is less. |
|What is the contribution limit for individuals age 50 and over? ||$6,000 or earned income, whichever is less. ||$6,000 or earned income, whichever is less. |
|Are contributions tax-deductible? ||Yes, if you and your spouse are not covered by retirement plans at work.*** If you or your spouse is covered, deductibility depends on your adjusted gross income. ||No. |
|How are withdrawals in retirement taxed? ||At ordinary income tax rates. ||Tax-free if account has been held at least five years and taxpayer is at least 59½ years old. |
|Are there penalties for early withdrawal? ||Yes, 10% on withdrawals made prior to age 59½; however, exceptions apply. ||Contributions may be withdrawn penalty-free at any time. Early withdrawals of earnings are subject to ordinary income taxes and a 10% penalty; exceptions apply. |
|Are there exceptions to early withdrawal penalties? ||Yes, in cases of death, disability, certain distributions for higher education or first-time home purchase, certain medical expenses and annuitized payments prior to age 59½. ||Yes, in cases of death, disability, certain distributions for first-time home purchase (lifetime limit of $10,000) and medical expenses, and annuitized payments prior to age 59½. |
|When do required minimum distributions begin? ||Age 70½. ||No required minimum distributions during the original account holder's lifetime. |
* The maximum contribution amount for Roth IRAs begins to phase out at modified adjusted gross incomes of $110,000 (single filers) and $173,000 (married filing jointly).
** Maximum annual contribution limits apply to any combination of traditional and Roth IRAs for the same individual.
*** Educators covered by a CalSTRS or CalPERS plan, or who participate in their 403(b) or 457 plan, generally are considered covered by a retirement plan at work. CTA does not give tax advice. Be sure to contact a tax attorney or advisor for information specific to your situation.
Can I Convert My 403(b) Plan to a Roth 403(b)?
Currently, you cannot convert a 403(b) plan to a Roth 403(b) plan. However, if a Roth 403(b) is available through your district, you could open one and direct future salary deferrals to the Roth 403(b). Learn more about Roth 403(b)s here. Note that there is no provision for a Roth 457 plan available at this time.
If you are leaving your job, you may be allowed to roll over your 403(b) account into a Roth IRA. Prior to Jan. 1, 2010, such rollovers were limited to taxpayers with modified adjusted gross incomes below $100,000. Keep in mind that you will have to pay ordinary income taxes on the amount of the conversion, so the same considerations of whether to convert from a traditional IRA to a Roth IRA apply. Be sure to discuss your situation with a trusted tax and financial advisor.