Roth IRA Conversion – Join the Party or Stay Home?

Roth IRA conversions are a hot topic for 2010.  Many investors are heading straight for the punch bowl by converting all of their IRAs in the quest for “tax-free for life”.  However the question of whether a Roth IRA conversion is suitable is very much circumstance specific and requires thoughtful (and sober) analysis first.

Roth Conversions in summary

For a primer on Roth IRAs, please click here.

The law currently allows for IRA owners to “convert” up to 100% of their existing tax-deferred accounts (traditional IRAs, rollover IRAs, SEP IRAs, SIMPLE IRAs, etc.) into a tax-free account, also known as a Roth IRA.  Once a regular IRA is converted to a Roth IRA, no taxes will ever be owed on any future investment earnings or distributions.  However, every dollar that is converted will be taxed at today’s ordinary income tax rates.

Anyone with an IRA is eligible for the conversion as there are no restrictions on age, income or marital status.  Conversions are irrevocable, except as noted later in this article.

What’s unique about 2010?

2010 has generated Roth conversion fever for two reasons:

1. Prior to 2010 there was an income restriction where if you had more than $100K in modified adjusted gross income (MAGI), you were ineligible for a Roth conversion.  This restriction has been lifted for 2010 (and future years) and therefore there is a large group of more affluent investors who were previously ineligible to convert.
2. If you convert your IRA to a Roth IRA in 2010, you can split the taxes owed in 2011 and 2012 as opposed to having to pay them all at once.  If you convert in future years, all the taxes are owed by the filing deadline in the following year.

Arguments for conversion:

1. Tax rates are at historical lows

2010 in particular is likely to be one of the last low tax years for the foreseeable future.  Therefore 2010 may be the last chance to convert at these more favorable rates.

2. Spread payment of taxes over two years (if converting in 2010)

You can liken this to an interest free loan from the government.  Rather than pay all the taxes associated with a 2010 conversion by April 15, 2011, you can split the taxes owed between 2011 and 2012.

3. Roth IRAs have no RMDs

Once an IRA investor turns 70.5, he or she must begin to take withdrawals from his or her IRA.  The amount that must be withdrawn is a percentage of the IRA based upon life expectancy tables and this percentage increases every year.

Investors who do not need the money and would rather leave their IRAs to their heirs, a Roth IRA can be a great way to accumulate income tax free.   It is worth noting however that non-spouse beneficiaries who receive a Roth IRA are subject to mandatory distributions.

4. Shift your wealth into a more protected environment

 

When you convert an IRA to a Roth IRA, taxes will be owed.  Normally it’s most prudent to pay these taxes from non-qualified (non-IRA funds).

For example, an investor has $1 Million in IRAs and $350K in non-IRAs.  If he were to convert his entire $1Million in IRAs to a Roth IRA, he would likely face a tax bill of approximately $350K (although the exact amount owed would depend on his state of residency and other factors).  Therefore post conversion, he would be left with just $1Million in a Roth IRA.

This technique may provide more asset protection by offering greater shelter for the investor’s entire portfolio.  However this argument should be examined carefully with the aid of a competent lawyer as laws will vary from state to state and limits may apply.  Furthermore, as an alternative, an investor, if eligible, may gain greater overall protection by rolling his IRA into a 401(k).

Another item to carefully consider is whether the investor is ever likely to make investments that generate unrelated business taxable income (UBTI) as this type of income may cause the equivalent of double taxation within the IRA. Therefore these types of investments should normally be reserved for investments held outside of any kind of retirement account.

 

5. Reduce the size of your estate and therefore potentially reduce estate taxes

 

This benefit applies to more affluent IRA investors although it’s a hard one to nail down at the same time.  2010 currently has no federal estate tax, however most agree it will return in some form in 2011 and beyond.  In fact under current law, in 2011 the amount above which estate taxes are owed (at rates up to 50%) is $1Million.

Therefore a Roth IRA conversion may make sense to lower the overall value of an otherwise taxable estate.

6. Roth IRAs are tax-free

Many investors have seen the value of their IRAs decline since 2008 and although the markets have partially recovered, now may be a particularly good time if you feel your IRA is at a relative low point in terms of value.

This is because you pay income tax on the value of the IRA at the time of conversion.  Therefore if you convert an IRA worth $1 Million in 2010 and it increases to $1.2 Million by the end of the year, you will still only owe taxes on $1 Million.

7. Great tool for deliberately generating taxable income

 

At Caledonia we had a client who had very little taxable income due to unemployment.  Further, with very little taxable income, he had deductions and credits that would have otherwise gone unused.  By executing a Roth conversion, he was able to convert a significant amount of his rollover IRA while paying almost no income tax in the process.

Another example of when this technique can be appropriately used is when an elderly investor is facing large medical expenses.  Without the significant taxable income that a Roth IRA conversion can generate, large deductions again could be wasted.

8. Beneficiaries are in a high (or higher) income tax bracket

 

Consider the case where an elderly IRA investor has particularly affluent children he has named as beneficiaries.  It may make sense for him to do a conversion and pay taxes at his lower rate and pass on a Roth IRA to his kids as opposed to leaving the IRAs where the kids will pay tax on IRA distributions at their marginal income tax rates.

 

9. You have non-deductible IRAs

Non-deductible IRAs are IRAs where there are after-tax contributions.  If they are substantial, this may make sense as there is no income tax to pay on after-tax amounts that are converted to a Roth IRA.  Therefore you are left with the benefit of having converted a tax-deferred account into a tax-free account at no cost.

The potential fly in the ointment with this strategy is that you cannot select to only convert your after-tax contributions.  Instead there is a pro-rata rule that applies.  For example, if you have an IRA worth $100K with a $50K basis (after-tax contributions) and you wish to convert $50K, you will have to pay income tax on $25K or 50% of the converted amount.

Arguments against conversion:

 

1. Do you really want to stick your head inside the lion’s mouth?

Roth IRAs are supposed to be tax-free.  This means all earnings and any subsequent distributions should be free from income taxes.

However, currently there are trillions of dollars invested in IRAs in America.  What is the likelihood that if a similarly large amount ultimately winds up in Roth IRAs the government will stand by its promise of keeping Roth IRAs tax-free?  Do you really want to take the bet Congress will overlook “millionaires” in the future that aren’t paying any taxes?  Congress didn’t back in the ‘70s and enacted some nasty legislation that lives on today in the form of alternative minimum tax (AMT.).

And it may not just be millionaires that may be ultimately at risk.  Social Security benefits were supposed to be tax-free; at least they were up until 1984 when Congress amended the Social Security Act.  Now up to 85% of a recipient’s benefit amount can be subject to income taxes.

2. Where’s the fire?

Although converting in 2010 may be tempting for some, it’s also worth remembering that one can convert in future years too.  Doing so preserves the ability to do tax-planning year to year, particularly when doing annual partial conversions (discussed below).

 

3. Conversions are irrevocable

 

Aside from the limited ability to unconvert (see discussion below), Roth IRA conversions are irrevocable.

 

4. Ruining a powerful tax opportunity if leaving money to charity

 

Although you cannot contribute your IRA to a charity while living, you can leave it to charity when you die.  Therefore if you have this intention, a Roth IRA conversion may be disastrous from a tax standpoint.  Since charities have tax-exempt status, there is no reason trigger income tax through a Roth conversion if the money is going to charity anyway.

 

5. Need the money in five years?

 

A Roth conversion probably doesn’t make sense in the short-term if you’ll need the money anyway.

6. You will be in a lower tax bracket in the future

 

This might apply if you’re a baby boomer on the verge of retirement.  Therefore why pay tax at a potentially higher rate now?

 

7. You don’t have the money to pay the taxes

 

This is a particular concern for someone under age 59.5.  If you don’t have a separate source of funds and instead make a withdrawal from your IRA to pay for the taxes owed, you’ll be hit with an additional 10% penalty on the withdrawal amount itself.

 

8. Conversion pushes you into a higher tax bracket

This is a concern because not only are you paying more taxes at the marginal rate, your effective tax rate may also increase due to phaseouts and high thresholds on certain deductions.

Partial Conversions:

Many investors find reasons for and against doing a Roth IRA conversion.  Therefore one approach is to hedge your bet or only partially convert your IRA.  By only converting a portion of your IRA into a Roth IRA, you may benefit from tax diversification if you wish to keep a portion of your portfolio in tax-deferred IRAs.  Alternatively executing partial conversions on an annual basis allow you to control how much income tax you pay from year to year.

 

 

Unconversions – for those with buyer’s remorse?

 

Interestingly, although the deadline for conversion is year end for any particular tax year, you may “unconvert” your conversion, partially or wholly, up until your tax filing deadline plus extensions the following year.

This may be particularly useful if you have underestimated your income and wish you hadn’t converted so much of your IRA.

Tricks:

1. Although the income limitation on Roth conversions has been lifted, there is still an income limitation of $167K (for married filing jointly taxpayers) where your ability to contribute is phased out.  However you can always make a non-deductible contribution to a traditional IRA without regard to income.  Therefore, if you fall into this higher income category, you can make your non-deductible contribution and then immediately convert it to a Roth IRA.  Further you can repeat this strategy every year.  The only important trap to watch out for is the pro-rata rule with respect to non-deductible IRAs (discussed above).
2. Although the deadline for conversion is always year end for any particular tax year, you can unconvert your conversion, partially or wholly, up until your tax filing deadline plus extensions the following year.  This has lead some investors to consider trying to arbitrage their conversion by deciding whether the performance of their investments indicates they should unconvert.  For example, say you have a $1 Million IRA that you convert to a Roth IRA.  You then invest it aggressively and lose 40%.  Provided you are still inside the deadline for unconverting, you could unconvert, and avoid paying income tax on $1 Million.  You could even convert your IRA to a Roth again and this time only pay taxes on $600K.

 

Traps:

 

1. If you are subject to a required minimum distribution (RMD), make sure you take it from your IRA before you execute a total Roth conversion.  This is very important because a Roth IRA conversion will not satisfy your annual RMD.
2. Make sure you have separate funds to pay your tax bill if you’re under 59.5.  If you intend to make a withdrawal from your IRA to pay for the extra taxes and you are under 59.5, you’ll be hit with an extra 10% penalty.  And if you don’t have the funds to pay for the 10% penalty, you’ll wind up taking even more from your IRA thus making a bad situation even worse.

 

Important Dates:

 

• 12/31/10 – This is the deadline by which you must convert if you wish for your Roth IRA conversion to be effective in tax year 2010.
• 4/15/11 – This is deadline date that 50% of taxes owed due to 2010 conversion are due the IRS.
• 10/15/11 – This is the final date (individual tax filing date plus extensions) by which a conversion for 2010 can be unconverted either partially or wholly.
• 4/15/12 – This is the date by which the other half of taxes are owed for a 2010 conversion.

 

Summary

Although the financial services industry is marketing the Roth IRA conversion in a push for new business, at Caledonia our general view is that conversions, especially 100% conversions, should be approached cautiously.  Every situation is unique and even in cases where the arguments appear compelling, make sure you are working with an experienced advisor or CPA who can offer you a thorough and balanced analysis.