Many people know how Roth IRAs and regular (contributory or rollover) IRAs work. But if you want a refresher, let me know and I’ll send you an educational piece.
Why all the fuss? Because the growth of a Roth IRA isn’t taxed and this is about the closest thing to a freebie that the federal government offers to taxpayers.
The Roth conversion process:
- take money out of a regular IRA
- contribute the entire withdrawal to a Roth IRA
- from another source, pay income tax on the withdrawal
You are paying taxes now in order to obtain future tax-free growth.
Rather than go through a bunch of tedious explanations, we examine a number of scenarios.
Scenario 1: Conversion during a low tax year
Scenario 1, Example 1:
Bill (40) got laid off in January and took the rest of the year off. His income was $12,000 from interest and dividends and a bit of unemployment. His credits, deductions, and exemption add up to $44,000, so his taxable income is -$32,000. Bill has $32,000 in his IRA so he can convert all of it to a Roth with no additional tax owed. At age 90, the after-tax value of Bill’s Roth IRA will be about 43% larger ($284,700) than the unconverted IRA.
Scenario 1, Example 2:
Sarah (40) terminated a business and took an operating loss of $100,000. Her income was $70,000 from interest and earnings. Her credits, deductions, and exemption are $50,000. Similar to Bill, Sarah can convert $80,000 to a Roth for no tax cost and gain a similar 43% ($709,200) advantage at age 90. If Sarah were to convert another $34,000 (maxing out her 10% and 15% tax bracket and costing $4,681 for income tax), the advantage is about 38% for a total after-tax advantage of $920,700.
Scenario 1, Example 3:
Roger (40) has taxable income of $34,000. He wants to max out the 25% tax bracket this year and expects to be in the 25% bracket during retirement. Roger converts $48,400 costing $12,100 in additional income tax. At age 90, Roger’s advantage is 16% ($196,600). If Roger needs $5,000 annually for living expenses beginning at age 70, the advantage is 19% ($85,100).
Typical reasons for low tax years:
- Getting laid off
- Deductions and exemptions wipe out most or all of your income, such as:
- ....Large charitable contributions
- ....Large casualty losses
- ....Large medical expenses
- ....Large nursing home expenses
- Business and other ordinary losses
- Net operating loss carry-forwards
- Selling a rental property at a loss
- Non-refundable tax credits
- Note: Capital loss carry-forwards do NOT help much
The general rule is that you convert to a Roth in years when your marginal tax rate is lower or the same as the marginal rate expected at age 70 ½.
Scenario 2: Conversion for the benefit of your heirs
Scenario 2, Example:
Abby (40) is a very successful entrepreneur, and thanks to a wildly successful IPO, she has considerably more than she needs for the rest of her life. Understandably, Abby can leave a substantial estate to her 2 children ages 7 and 10. A Roth IRA is tax free for Abby’s lifetime and also for the children’s lifetimes. Therefore the Roth IRA is one of the best items to bequeath to your heirs. Abby’s IRA is $100,000 and she expects to be in the highest tax bracket for the remainder of her life. It costs $35,000 in tax to convert, but at 90, the after-tax value of Abby’s Roth IRA is about 22% larger ($531,700) than the unconverted IRA. If the heirs drawdown the inherited Roth IRA over 40 years, the additional advantage is about 47% ($12,809,600).
The general rule is that when all these are true …
- You expect to be in the highest tax bracket forever
- You do not need your IRA assets to live on
- Your estate is to benefit your children
- You can pay the conversion tax with other assets
… You should consider converting everything to a Roth IRA as soon as possible.
Scenario 3: Opportunistic conversion
Scenario 3, Example:
Angus (40) had a $500,000 IRA invested in a IPO stock that was clobbered in the recent bear market, so the IRA is only worth $100,000 now. Angus is completely confident that the company will survive and grow and that the IRA value will recover back to $500,000. Needless to say, we think Angus is nuts, but if he is right, it sure is a great time to convert to a Roth. Angus is in the 35% tax bracket this year but expects to be in the 25% bracket when he is 70 ½. Converting now costs $35,000 in tax, but at age 90, the Roth is about 8% larger ($214,000) than the unconverted IRA, and that is if the stock never recovers. If the stock recovers, and is replaced with diversified investments, the Roth IRA advantage is 34% ($3,528,000).
The general rule is if you think your IRA is temporarily at a low valuation, then it may be a good time to convert to a Roth even if your tax bracket is higher now than in retirement.
Scenario 4: Tax diversification conversion
Scenario 4, Example:
Matt (40) has a $100,000 IRA and he doesn’t believe anyone can forecast future tax rates, plus he cannot forecast his income before or after retirement. Since the tax rates are an unknown, Matt wants to consider having regular IRA and Roth IRA accounts . Matt can choose a low-income year for converting some of the IRA to a Roth, and in retirement he can withdraw from the IRA in low-income years and from the Roth in high-income years. Matt gains better control of his taxes since he has access to taxable income from the IRA and tax-free income from the Roth.
General Roth conversion rules:
- You never, ever want to show a negative taxable income on your tax return. A Roth IRA conversion can be used to get to zero income at no cost.
- Never withhold taxes on a Roth conversion (pay the taxes from external sources).
- If your marginal tax rate is 15% (federal), consider a Roth conversion to use up the entire 15% bracket.
- Roth IRA accounts are among the best possible assets to pass to your heirs. Convert more aggressively if you plan for your heirs to get most or all of your Roth IRA.
- Those expecting to be in the highest marginal tax bracket forever may benefit from an immediate conversion of the entire IRA balance.
- The longer you can compound the Roth IRA, the bigger the advantage of converting. And the longer your heirs hold onto the inherited Roth IRA, the bigger the tax advantage to them.
- Having both an IRA and a Roth IRA provides tax diversification. With both IRA and Roth IRA accounts, you can have better control over your marginal tax rate every year. Generally you want may want to take IRA distributions in low tax years and Roth distributions in high tax years. Having some IRA and Roth IRA assets can be very beneficial for managing for tax rates in retirement.
- When your IRA has a temporarily low valuation, consider converting to a Roth.
- You are not permitted to convert any of your RMD (required minimum distribution).
- In some select cases, estate taxes can be reduced thanks to a Roth conversion.
- If you convert in 2010, you have a choice about paying the resulting income tax. You can report all of the income (from the Roth conversion) in 2010 or report 50% of the income on your 2011 tax return and the other 50% on your 2012 tax return. Normally you want to delay paying taxes, but you must consider future increases in tax rates that make could make waiting more costly.
Some things that could occur that could make the Roth conversion less valuable or even worse than not converting:
- Income tax rates are reduced substantially or repealed and a national sales tax replaces the tax revenue.
- You plan to gift to charity all of your required minimum distributions from your IRA.
- You are unable to pay the income tax on the IRA distribution with other assets reducing the amount converted to the Roth IRA.
- The stock market drops precipitously after the Roth conversion. By waiting you could have converted for less tax cost.
- The income from the Roth conversion may cause your Medicare Part B premiums to increase significantly, at least temporarily.
- Many deductions and credits on your tax return are linked to your AGI (adjusted gross income). A Roth conversion will increase your AGI, which may adversely impact other (non-obvious) areas of your total tax. One example, if you are expecting financial aid for college, a Roth conversion can reduce the aid award.
All may not be lost however: If you convert to a Roth, you may recharacterize (move the money from the Roth IRA back to the IRA) some or all of the conversion reducing the taxes owed. There are strict time limits on when the recharacterization may occur.
As you can see, analyzing a Roth conversion is complex and involves multiple factors. Financial planners or tax professionals that perform tax planning are able to help you make wise decisions about Roth conversions.
Assumptions used in all the scenario examples:
- The conversion tax year is 2010.
- The marginal tax rate in retirement is 25%.
- Long-term capital gains rate is 15%.
- Any state income tax is not considered.
- Unless otherwise noted, no living expenses are taken from either the IRA or the Roth IRA. When needed, living expenses are after tax and are to be taken from the IRAs starting at age 70 and increase 3% annually.
- Return rate on IRA investments averages 7% consisting of 2% qualified dividends, 1% interest, non-qualified dividends, and short-term capital gains, and 4% long-term capital gains.
- Each year, 40% of that year's long-term gains are realized.
- No tax credits are affected by converting to the Roth
- All tax owed is paid in the year following the Roth conversion from other resources (not from the proceeds of the IRA distribution, therefore all the proceeds go into the Roth IRA).
- The advantage of the Roth conversion is measured compared to the after-tax value of the unconverted IRA.
- The advantages of a Roth conversion shown in the examples are computed using an ICM-developed worksheet, and while believed accurate, cannot be guaranteed.
© Copyright 2010, Investor's Capital Management, LLC
