A new long-term tax savings opportunity exists for higher-income taxpayers. But as with many investment decisions that require consideration of pre-tax and after-tax returns, the costs and benefits of Roth conversion may not be obvious to most investors. A number of factors should be considered in evaluating whether to convert to a Roth: the size and asset allocation of your overall investment portfolio, the cumulative amount of after-tax contributions in your individual retirement accounts, when you expect to draw upon your IRA, and your current and expected future marginal tax rates, to name a few. For many high-income taxpayers, Roth conversion offers a very significant opportunity to protect retirement investments from future taxes. In this article I provide some facts about Roth IRAs and offer my opinions about issues that should be considered in an evaluation of whether to convert to a Roth.
Taxes are the key difference between a Roth IRA and a regular IRA.
With a Roth IRA, taxpayers make after-tax contributions, which can then grow tax-free over time. Regular IRAs involve contributions that may or may not be deductible for the taxpayer, depending on their tax bracket. Upon distribution from a regular IRA, all appreciation and any pre-tax contributions would be subject to tax at then-prevailing ordinary rates. In addition, regular IRAs require the account holder to take minimum distributions beginning at age 70 ½. Roth IRAs have no such requirement. Any distribution you to elect to receive will be free of tax in most instances. According to the IRS: Unlike a traditional IRA, you cannot deduct contributions to a Roth IRA. But, if you satisfy the requirements, qualified distributions (defined in Publication 590) are tax free. Contributions can be made to your Roth IRA after you reach age 70 1/2 and you can leave amounts in your Roth IRA as long as you live.
Almost everyone is eligible for Roth conversion.
While high-income taxpayers are not permitted to make direct contributions to a Roth, a change in tax law, beginning with the 2010 tax year, gives most taxpayers the ability to convert existing, regular IRAs (including SEP-IRAs and Rollover IRAs) to Roth IRAs.
Opinion: Roth IRAs have not been widely available for higher-income taxpayers due to the income limitations. For many such taxpayers, Roth conversion offers a highly attractive way to shield retirement investment accounts from future taxes.
Roth conversion accelerates taxes.
If you make a Roth conversion, the value of the converted assets will be subject to ordinary income tax (with a few exceptions, discussed later) in the year of conversion. However, for conversions effected in 2010 only, you may elect to pay the taxes resulting from conversion in 2010, or to defer the tax by spreading the income equally between 2011 and 2012.
Opinion: The IRS is offering taxpayers a cash flow benefit by allowing them to defer the recognition of income until 2011 and 2012. However, marginal tax rates are currently scheduled to increase in 2011.
Current year IRA contributions may be converted.
If you do not already have an Individual Retirement Account, but are otherwise eligible to make regular IRA contributions, you may establish an account before April 15th and fund it with your contributions for both 2010 and 2011. You may then immediately convert the traditional IRA to a Roth IRA.
Opinion: Immediate conversion offers a means for higher-income taxpayers to effectively make Roth contributions without regard to the income limit.
Non-deductible IRA contributions are not subject to tax at the time of conversion.
If you have an individual retirement account that consists entirely of non-deductible contributions (i.e. contributions for which you did not claim any prior tax deduction) then you will not owe tax upon conversion to a Roth, because the tax has already been paid. However, you would be obligated to pay income tax on any appreciation in the account. If you have both pre-tax and after-tax accounts (including, for example, IRA rollovers from 401k or 403b plans), you may not cherry-pick accounts for conversion. Rather, the tax on converted amounts will be based upon an IRS formula designed to capture the value of any account (or part thereof) upon which tax has not already been paid.
Opinion: Roth conversion may be especially attractive for individuals whose IRAs consist primarily of after-tax contributions, since there would not be much tax owed as a result of conversion and the account would subsequently be shielded from tax.
Note that the amount of tax owed as a result of Roth conversion will be dependent on your income (before the effect of conversion), your marginal tax rate, the total value of all Roth conversions effected by you during the tax year, the value of IRAs that have not been converted, and the ratio of after-tax IRA contributions to overall account values, among other factors. The specific tax rules are complex and you are advised to consult your financial advisor and/or tax accountant regarding the tax implications of conversion, given your personal circumstances.
Partial Roth conversions are permitted.
You are allowed to convert all or part of one or more individual retirement accounts to a Roth IRA.
Opinion: Depending on your marginal tax rate and the composition of your overall investment portfolio, including the value of investments held in taxable accounts, a partial conversion may be the most effective way to minimize your overall tax liability.
Roth IRAs require no minimum distributions.
Unlike traditional IRAs, which require minimum distributions beginning at age 70 ½, there are no required minimum distributions with Roth IRAs.
Opinion: if you do not have any need to draw upon your retirement savings, Roth IRAs offer an estate planning benefit. Your Roth account may grow, tax-free, for the rest of your life. Moreover, since taxes are paid at the time of conversion, Roth IRAs provide an additional estate planning benefit by reducing the marginal size of your taxable estate and eliminating the double taxation of IRA assets that might otherwise occur.
One important consideration that articles about Roth conversion have generally not addressed in detail, is that taxes resulting from Roth conversion should be paid from a taxable account. The headline reason often cited is to avoid IRA penalties for non-qualified IRA distributions, which would generally apply to taxpayers younger than age 59 ½ if taxes were paid directly from the IRA. But this is only part of the story. A more important reason is to insulate additional savings from future taxes. By paying tax from ordinary taxable accounts rather than tax-advantaged accounts, taxpayers are effectively able to gross-up the value of their tax-advantaged investments by the amount of tax paid. If one accepts the primary rationale for IRAs--- that they allow tax-deferred compounding of investments over a long period of time --- then this benefit is equivalent to a dramatic, one-time increase in the after-tax, statutory contribution limit. In other words, the IRS is giving taxpayers a chance shelter up to 39.6% of the value of their IRAs from future taxes, depending on their tax bracket. For taxpayers with significant investment assets in taxable accounts, an expectation of equal or higher marginal tax rates and positive investment returns, and large traditional IRA balances, this opportunity could be worth tens of thousands of dollars or even more. Even for taxpayers who expect their marginal tax rates to decline in the future, the benefit of tax free compounding could be substantial. You are invited to use the Roth Conversion Calculator to help you assess the impact of conversion given different assumptions about your investment portfolio, future investment returns and tax rates.
Please note that all of the information presented herein is for educational purposes, is general in nature, and may not be appropriate for you. It should not be relied upon or construed as financial, legal, or tax advice or recommendations. You should speak with your financial advisor for assistance in evaluating the risks and benefits of Roth conversion given your particular financial circumstances, or you are welcome to contact the author.
James P. Dowd is a CFA charter holder and a CPA.