Affluent taxpayers have an attractive new retirement option available to them this year, the Roth IRA.
For the first time, income restrictions on converting to a Roth IRA no longer apply. A whole new group of affluent taxpayers is now eligible to convert traditional retirement accounts to Roth IRAs. In addition, there is a one-time benefit this year that delays recognition of taxable income generated as a result of converting.
Unfortunately, in spite of the tax incentives, there is no simple answer to the question of whether you should convert your retirement funds to a Roth IRA.
Roth IRAs differ from traditional IRAs and other qualified retirement plans based on the federal income tax treatment of their contributions and withdrawals. Generally, contributions to a traditional IRA or qualified plan are tax deductible and the account’s earnings and contributions are taxed when withdrawn. As a result, both contributions and earnings are tax-deferred. There are age-based restrictions on your ability to withdraw contributions from a traditional IRA, as well as age-based minimum distribution requirements and new-contribution limits that may restrict your estate planning options.
A Roth IRA is a special form of IRA in that contributions are not deductible when they’re made, but contributions and earnings are tax-free when withdrawn. Unlike traditional IRAs, there are no required minimum distributions from a Roth IRA and you can withdraw your contributions with more flexibility than a traditional IRA. In addition, there are no age-based limitations on your ability to contribute to a Roth IRA.
New Rules for Roth IRAs
Before 2010, contributions and conversions to Roth IRA accounts were restricted to taxpayers with modified adjusted gross incomes below prescribed phase-out amounts. Beginning in 2010, the income limitations for converting retirement funds to a Roth IRA―but not for making new contributions―have been eliminated.
Now, you can convert to a Roth IRA regardless of your income. You can convert one or more retirement accounts to a Roth IRA, and you can convert the entire balance in the account or only a portion of the account. If your income exceeds the cap for Roth IRA contributions, you can make nondeductible contributions to a traditional IRA and then convert them to a Roth IRA.
Converting to a Roth IRA is a taxable event. When you convert funds from a traditional IRA or an employer’s qualified plan, the retirement funds you convert are generally considered taxable income for federal income tax purposes. Because you contributed pre-tax earnings into the retirement account you’re converting, the funds are taxed when you withdraw (convert) them―including both the pretax contributions and any accumulated earnings.
For 2010 only, there is an added incentive for converting. Unless you elect otherwise, you defer recognition of the resulting income by spreading it over the following two years, 2011 and 2012. This may not be beneficial, however, if income tax rates increase during 2011 or 2012.
Major Variables to Consider in Projecting the Effects of a Roth Conversion
The decision to convert to a Roth IRA is, at heart, a tax and financial modeling exercise. By its very nature, this type of analysis involves uncertainty―there’s always the possibility that the tax rules will change. Other uncertainties and variables include the following:
At what age do you plan to retire and what is your anticipated life expectancy?
What do you estimate to be the future return on your retirement investments?
What do you predict your tax bracket and the applicable income tax rate(s) will be during your retirement?
What is the probable value of your estate and what estate tax obligation do you anticipate at the time of your death.
Will you need your retirement accounts to provide necessary cash flow before or during your retirement?
Factors Favorable to Converting
Generally, Roth conversions are most beneficial if you are wealthy or a young, high income earner and you likely won’t need your retirement funds to support your lifestyle.
The decision to convert some or all of your retirement funds to a Roth IRA is ultimately a personal one, factoring in your own objectives and preferences and considering the range of results from alternative financial models. However the following factors, when present, are generally supportive of a decision to convert.
You anticipate that you will be in a higher tax bracket during retirement.
The retirement funds you convert are generally taxable at the time of conversion. If you believe you will be in a higher tax bracket when you retire―or that the federal tax rates will simply be higher then―converting to a Roth IRA now may make financial sense.
If you convert, you’ll pay taxes on the funds in your retirement account now, at the lower tax rate, and all future earnings in the Roth IRA will accumulate tax-free. Of course, you’ll be paying taxes on all the funds in the account that you’re converting at once, rather than spacing the taxes over a number of years during retirement. But the tax savings may more than compensate for the accelerated tax payment.
The investments in your retirement account(s) have dropped in value.
The taxable amount of the retirement funds you convert to a Roth IRA is based on the current value of the account, not on the amount of your initial contributions. If your investments have dropped in value but you’re expecting them to rebound, you’ll pay less in taxes by converting before the investments regain their value.
If you guess wrong and the value of your retirement investments continues to drop, you have the option to recharacterize your retirement account ―e.g., undo the conversion―until the extended due date of your tax return. You can choose to recovert at a later date, after your investments begin to appreciate.
The balance in your retirement account is relatively small and you are relatively young.
If you convert your traditional account while the balance is relatively small, the tax cost is also relatively small and the retirement funds can grow tax-free for many years to come.
You are at least 70 ½ years of age and you have nonretirement funds to pay the tax due on conversion.
As the owner of a traditional IRA account, you must take a taxable required minimum distribution each year after you reach the age of 70 ½. Roth IRA owners aren’t subject to the same minimum distribution requirements. If you won’t need the funds in your retirement account for future living expenses, they can remain in your Roth account and become a part of your estate.
You can preserve the maximum amount of money for your heirs by paying the tax due on conversion using personal funds outside of the retirement account and allowing 100 percent of your retirement funds to continue to grow free of tax.
You are planning to fund a Unified Credit Trust or Generation Skipping Tax Exemption Trust with IRA assets.
The Roth IRA is a powerful asset with which to fund these trusts because the exemption for estate tax or generation skipping tax is funded on an after-tax basis.
You are likely to owe federal estate taxes upon your death.
By converting to a Roth IRA during your lifetime, you reduce the value of your taxable estate and lower the effect of possible future tax rate increases as post-death distributions to beneficiaries are tax-free.
You have federal tax benefits that can offset some or all of the taxable income otherwise due on conversion.
You can apply certain tax attributes―such as a charitable deduction carryforward, investment tax credit or net operating loss carryforward―to reduce your effective tax rate for the conversion, enhancing its financial benefits.
Factors Not Favorable to Converting
Converting to a Roth IRA may not be the best decision if you anticipate you’ll be in a significantly lower tax bracket during retirement, you’ll need your retirement funds for living expenses, or you are only a few years away from retirement. Likewise, if you’re planning to make a substantial bequest to charity, the taxes you’ll pay will reduce the funds available for charity, as well as the estate tax exemption.
Finally, if the taxable income you’ll recognize as a result of converting will put you in a higher tax bracket, you may prefer to convert your retirement funds gradually, over a number of years.
Making the Best Decision Regarding Roth Conversion
Because of the complex interplay of factors involved in this important financial decision―and the significant tax and financial consequences―it’s critical that you consult with your advisor at Bader Martin before converting to a Roth IRA.
We can help with financial projections and tax analyses, including strategies to convert over multiple-years or convert partial accounts.
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For an overview of the basic tax rules governing traditional and Roth IRAs, as well as the rules for converting retirement funds to a Roth IRA, refer to our previous post Have an IRA?
