Special Roth IRA Conversion Opportunity


The tax rules allow anyone (even rich people) to roll over their IRA into a Roth IRA. The wealthier you are and the more likely you are to leave your IRA assets to your children (and not spend them in retirement) the more likely a Roth IRA conversion is a good idea for you. It is very likely that income tax rates in the US will be going up significantly which is another reason to consider converting to Roth.

What are the significant differences between a traditional IRA and a Roth IRA?
In a traditional IRA you get the tax deduction (now) for contributed dollars, assets grow on a tax-deferred basis, but you must pay taxes on distributions from the IRA in retirement. With a Roth IRA you don’t get a tax deduction for contributed dollars (contributions are after-tax), assets grow on a tax-free basis, and distributions in retirement (or after age 59.5) are income tax-free. You can make contributions to a Roth IRA after age 70 as long as you (or your spouse) have earned income. This is not allowed in a traditional IRA. Roth IRA owners are not required to take distributions, but traditional IRA owners must take taxable distributions starting at age 70.5 (required minimum distributions).

What are the special Roth conversion rules?
Prior to 2010 Roth conversions were only allowed for people with modified adjusted gross income of $100,000 or less. After January 1, 2010 this option is open to everyone. Another positive change for 2010 conversions only is the option to delay recognizing (and paying taxes on) the income on conversion equally into 2011 and 2012. For example, if you converted $200,000 of IRA assets to Roth in 2010 you have the option of recognizing $100,000 of that income in 2011 and the other $100,000 in 2012. After a conversion you must wait 5 years to withdraw the money from the Roth tax-free.

Roth IRA conversion sounds good, where’s the catch?
To convert to a Roth IRA you must recognize that amount as income and pay income tax on that income. To convert $200,000 in IRA assets to Roth you may have to write a check for $80,000 (assuming a 40% marginal tax rate) to pay the taxes on that conversion (either now or spread over 2011-2012 as discussed). In addition, you should pay those income taxes from a taxable account (not from your IRA or 401K). So to convert you need to be willing to write a big check now to pay the taxes for the conversion, and you should have enough money in a separate taxable investment account to pay those taxes. Paying the tax on the conversion with IRA assets themselves defeats the purpose of the conversion, especially if you are under age 59.5 where you would be subject to a 10% penalty as well. It is tough for most people to voluntarily pay more taxes now than they have to, for a benefit many years in the future. It also goes against most traditional tax planning which says to always defer paying taxes as long as possible.

Who should think about converting to Roth? Who shouldn’t?
The most favorable situation to convert to Roth is a wealthy person who expects their tax rate in retirement to be higher than it is now, who will not be spending any of their IRA in retirement, who expects to live a long time, and plans on leaving the Roth IRA assets to the next generation. The Roth does not have mandatory distributions beginning at age 70.5 like a traditional IRA, so the Roth allows you to extend the tax-free life of your retirement assets. This can potentially result in a greater financial legacy for your heirs. Some people may benefit by doing a partial Roth conversion in years when their income (and tax rate) is down temporarily for one reason or another (recession, tax losses) to take advantage of their lower than usual tax rate.

People who will not want to convert to a Roth are those that cannot afford to pay the tax on conversion now, those who don’t have enough assets in a separate account (outside of their IRA/401K’s) to pay the taxes, and/or expect their tax rate in retirement to be substantially lower that it is now. Older people who are planning on giving/leaving their IRA assets to charity are usually better off sticking with the traditional IRA. If you are nearing retirement and haven’t saved enough, you’re likely best not converting.

Is a partial Roth IRA conversion the answer? Tax rate diversification
Most investors will likely do a partial conversion to Roth rather than a 100% conversion. You could also spread your Roth conversions over several years to spread out the income (and tax) hits. It is probably smart to diversify your future tax rate bet by having some Roth IRA assets (tax-free distributions) and some traditional IRA assets (taxable distributions). This will allow more creative tax planning in retirement in terms of timing your withdrawals from different pools of assets with different tax implications. Converting some of your IRA to Roth is a hedge against future tax rate increases.

What are the risks of converting to Roth now?
One risk is that you end up with a significantly lower tax rate in retirement than you thought (due to lower income or some other reason). There is always the risk that the US government will change the Roth rules in the middle of the game, and somehow limit the tax-free status of your Roth IRA assets.

This is complicated, get professional help!
There are many significant factors with a Roth conversion to consider, some of which we haven’t even mentioned (such as the alternative minimum tax). Each person’s situation is different. Consult with your CPA and investment advisor to see if a Roth conversion is a good option for you.

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