Whether to consider a Roth IRA before tax-filing deadline

George Chamberlin for SanDiegoSource writes: Pay me now or pay me later. That is the concept behind tax deferral, an investment approach many people have used over the years in accounts like their employer-sponsored retirement accounts.

Taxes on the growth in the account, either by appreciation or income, are postponed to a time when the money is withdrawn or passed along to a beneficiary.

So, it is at this time of the year, when we near the tax filing deadline, some people are reminded of the opportunity to transfer the tax-deferred accounts to ones where future growth will be tax-free. Transferring from a traditional IRA to a Roth IRA, a move from a tax-deferred account to one that is tax-free, is something people planning for retirement should consider.

While there are income limits that ultimately preclude people from funding these retirement accounts, there are no such limits on conversion. Prior to 2010, individuals with incomes over $100,000 were prohibited from making the switch. That changed in 2010, when the rules were changed removing any income limitations.

This opened the floodgates for many people who had been denied the opportunity to make the conversion. It also, of course, created a windfall for the federal government because the change is a taxable event releasing billions of tax sheltered dollars in tax-deferred accounts.

Making a Roth conversion is not necessarily the right thing to do for all savers and investors. The Schwab Center for Investment Research says such a move makes sense if you think you will be in the same or a higher tax bracket when you withdraw the money in retirement. It also helps to have a long time horizon to allow the tax-free benefits of a Roth to work, and if you can pay the taxes due with funds from outside the IRA you are converting.

These are not absolutes and professional advice is important in making such a decision, especially if large amounts of money are involved. For instance, it is not always wrong to pay taxes from the proceeds of the traditional IRA as long as you are over the age of 59 ½. Doing so before that age would not only trigger a tax liability on the money being transferred, it would also cause a ten percent early withdrawal penalty.

Making the switch also has some estate considerations. Since the growth of a Roth IRA is tax-free, there is no requirement to begin making mandatory withdrawals at the age of 70½ as is required with traditional retirement accounts. It also means the assets will pass along to beneficiaries after death without any tax liabilities on their part.

A Roth conversion is simply a decision on when you want to pay taxes. The likelihood of higher income taxes in the future makes the change practical. By deferring taxes you are allowing your nest egg to grow, creating a larger lump sum that probably will be taxed at a higher rate. Paying the piper now could save you — and your beneficiaries — handsomely down the road. It may seem a bit painful to take on a big tax bill now, but just think how much bigger it will be if you wait.