Guest Post – Roth IRA Conversions

May 7, 2010

As part of my arrangement with our sponsors, I have invited each of them to write a guest post with a subject matter that is pertinent to our target audience, and further explains the types of products and services available from their companies.

Mr. Cal Brown strikes again…

ROTH IRA CONVERSION

SHOULD YOU DO IT?

Summary

A Roth conversion could save your heirs and you thousands of dollars in taxes, but is it right for you? Many people with high incomes have not been eligible for Roth conversions in the past; however the law changed in 2010 making almost everyone eligible. This article compares traditional IRAs and Roth IRAs, explains the changes regarding Roth conversions, and provides guidance as to whether a conversion makes sense.   

Comparing Traditional IRAs versus Roth IRAs

Before diving into Roth conversions, there are a few key differences between traditional IRAs and Roth IRAs worth highlighting. Specifically, these accounts differ in the tax treatment of contributions, withdrawals and required minimum distributions. 

• A traditional IRA is a tax-deferred account generally containing pre-tax contributions, while a Roth IRA is a tax-free account containing only after-tax contributions.
• Contributions to traditional IRAs are generally tax deductible, but contributions to Roth IRAs are not deductible.
• Growth of  both traditional IRAs and Roth IRAs is tax-deferred.
• Withdrawals from a traditional IRA are taxed as ordinary income in excess of basis (you have basis if you have ever made a non-deductible contribution), whereas withdrawals from a Roth IRA are tax-free under certain conditions. For a withdrawal from a Roth IRA to be tax-free, the account must have been in existence for at least five years and the withdrawal must be on account of death, disability, attainment of age 59½, or a first time home purchase.
• Another difference relates to Required Minimum Distributions (RMD) which are mandatory withdrawals from certain retirement accounts beginning at age 70½ based on the owner’s life expectancy and account value. Traditional IRAs are subject to RMDs, whereas Roth IRAs are not subject to RMDs during the owner’s lifetime. Roth IRAs are subject to RMDs when inherited by a beneficiary.
• Tax treatment at death is significantly different. The full value of a traditional IRA (in excess of basis) is taxable to your heirs (except a spouse) at your death. However, the heirs can elect to receive distributions over their life expectancy, but those distributions are taxable in the year received. The entire value of a Roth IRA is income tax-free to your heirs after your death.

In summary:

Roth Conversions

A Roth conversion is the process of moving funds from an existing traditional IRA into a Roth IRA. The amount converted is subject to federal and state income taxes in the year of conversion. Under the prior law, you were only eligible to convert if your modified adjusted gross income was less than $100,000.  You are eligible to convert if your tax filing status is single or married filing jointly, but you are not eligible if your filing status is married filing separately.

Starting January 1^st, 2010, the $100,000 modified adjusted gross income limit for Roth conversions is permanently suspended. This means anyone, even taxpayers who file their return as married filing separately, will be eligible to convert. While the income restriction will be permanently repealed, there is always a possibility these laws may change in the future.

If you convert in 2010, you will have the option to pay the tax on your 2010 return, or you can spread it evenly across tax years 2011 and 2012. The ability to spread the tax over two years is a benefit from a time value of money standpoint and is only available for 2010 conversions. Due to the uncertainty surrounding tax rates in 2011 and 2012, an individual calculation based on your particular circumstances will be necessary to determine whether to pay the taxes on the conversion in 2010 or spread it over two years.  There is no general answer that applies to everyone. You or your tax advisor should run a “what if” based on your various sources of income and your deductions in those three years.

Does a Roth conversion make sense for you?

Although everyone becomes eligible for a Roth conversion in 2010, this does not necessarily mean it makes sense for you. There are several issues to consider, including your current tax rate versus expectations of future tax rates, your time horizon, availability of liquid assets to pay the tax, and your intent to leave assets to your heirs. 

1. Tax Rates

Current and future tax rates are two important considerations when deciding to effect a Roth conversion. If you believe you will be in a higher tax bracket later, it makes sense to convert in 2010 because the taxes you pay today will be less than the taxes you will pay when you make a withdrawal from your traditional IRA in future years. If you believe tax rates will increase in the future, you should also consider a conversion this year, even if you are currently in a high tax bracket and will be for the foreseeable future. Conversely, if you are currently in a high tax bracket but expect to be in a lower tax bracket later, it makes sense to pay the tax on IRA distributions in the future rather than paying taxes on the conversion at your current higher tax rate.

1. Time Horizon

You should consider a Roth conversion if you don’t need the money for many years.  On the other hand, if your time horizon for needing withdrawals from your IRA is only a few years from now, the taxes paid on the conversion will probably exceed the Roth IRA’s potential for tax-free growth.  Also, remember if you open a new Roth IRA for the conversion, a distribution within five years of conversion may be subject to a 10% penalty.

1. Paying the Tax

It is important to consider whether you have liquid assets available (outside your IRA) to pay the taxes due on the conversion. If your only source for paying the tax is your regular IRA or another retirement account, converting to a Roth IRA is not very attractive.  Paying taxes on the conversion with IRA funds will result in additional income tax on the withdrawal, the loss of tax-tree growth on that amount, and could also result in a penalty if you are under age 59½.

4. Partial Conversion

In some cases, it may not make sense to convert all of your IRA assets because of the potentially large amount of tax you will pay on the conversion. In this case, consider a partial conversion.  There are several benefits to a partial conversion, including the ability to stay within a certain tax bracket or to avoid squandering itemized deductions.  In other words, if your adjusted gross income (AGI) is less than your itemized deductions, you could convert part of your IRA — this will increase your AGI, but since you have excess itemized deductions you pay zero tax on the conversion.

IRA Aggregation Rule – Warning!

A word of caution: There may be a complex tax calculation when converting non-deductible IRAs. You must include all your IRAs—all taxable and non-taxable contributions when calculating the conversion, not just the IRA you are converting.  However, you are not required to include employer sponsored retirement plans. If you have previously made non-deductible IRA contributions, part of the amount you convert will not be subject to tax. You are required to split the amount converted between deductible and non-deductible based on how much the non-deductible contributions represent of the total IRA account values. For example, if you have made non-deductible contributions of $10,000, the total value of your traditional IRAs is $100,000, and you decide to convert $20,000, then 10% ($10,000 out of $100,000) of your conversion, or $2,000 ($20,000 x 10%), would not be taxed. You would pay tax on the remaining $16,000. 

1. Estate Planning

A Roth IRA is a very attractive asset to pass onto your heirs because the account will continue to grow tax-free and your heirs will not have to pay income tax on their withdrawals. Your heirs will be required to take RMDs on the Inherited Roth IRA, but the distributions will be tax-free. Once distributed, your heirs will have to pay tax on future income and growth. Depending on their age at the time of inheritance, the tax-free build-up benefit could be very large.

Conclusion

If you have a traditional IRA you are likely eligible for a Roth conversion this year. A Roth conversion could save your heirs or you money on taxes.  As you can see, there are multiple considerations and a rather high level of complexity. You may not want to try this at home without professional help. Seek out a qualified wealth manager who is conversant not only in investments, but also in complex tax calculations and projections of future values based on stochastic modeling (AKA Monte Carlo simulations).

Cal Brown  CFP®, MST

Vice President of Planning

Cal has 25 years of experience in the financial services field. He is a member of the Financial Planning Association and Chairman of the National Capital Area Chapter (FPA-NCA).

The Washingtonian magazine recently named Cal as one of the top 33 financial planners in the greater Washington, D.C. metro area.  Mr. Brown has three professional contributions published in the Journal of Financial Planning and has authored articles appearing in Wealth Manager and Financial Planning magazines. He has appeared on CNBC, Fox 5 DC, the PBS “Morning Business Report,” WAVA-FM (Washington, D.C.), and has been featured in the Wall Street Journal. He has also been quoted in Kiplinger’s Personal Finance magazine, U.S. News and World Report, Smart Money Magazine, CNNfn, Financial Planning magazine, Mutual Funds magazine, andInvestment News.

Cal manages all planning efforts and special projects including conducting financial analyses for clients, is a member of The Monitor Group’s Investment Committee, and serves as a relationship manager for many of the firm’s clients. Cal is also responsible for the firm’s operations in the President’s absence.

He received his Masters of Science in Taxation at American University in Washington, D.C., and graduated cum laude from the University of Arkansas with a bachelor’s degree in Business Administration.

© 2010, Jeff Saylors. All rights reserved.