Does it Make Sense to Convert to a Roth IRA?August 2010
The question about whether or not to convert a Traditional IRA to a Roth IRA has received much attention this year. A significant change in the IRA rules and the anticipated income tax increases for 2011 have compelled many investors to seek guidance in making this important decision.
In the past, you could convert your Traditional IRA to a Roth IRA only if your income was under $100,000. But in 2010, this restriction was removed. This has made Roth IRAs accessible to even the highest income earners.
Unlike a Traditional IRA that is funded with pre-tax dollars, a Roth IRA is funded with after-tax dollars. While distributions from a Traditional IRA are subject to income tax, distributions from a Roth IRA are income tax-free. Ordinarily, taxpayers have expected to be in lower income tax brackets when they retire, so deferring income taxes until then has made sense. However, with the top Federal income tax rate currently at 35% but scheduled to surpass 43% by 2013, many taxpayers are rethinking this assumption.
The Benefits of a Roth IRA
While contributions to a Roth IRA are not tax deductible, any earnings and appreciation are tax-free, as long as you are over age 59 1/2 and at least five years have passed since you established your Roth IRA. And, unlike a Traditional IRA, there are no required minimum distributions. This provides you with the opportunity to be in control of your distributions during your lifetime.
A Roth IRA can be especially beneficial if you do not need to use the assets in your IRA and plan to pass them to heirs. Since there is no distribution requirement with a Roth IRA, the entire account can remain in place to grow tax-free during your lifetime.
Deciding Whether to Make the Switch
Weighing the benefits against the disadvantages of converting—most notably the immediate income tax consequence and the loss of future growth of the assets used to pay taxes—can be very complicated.
The decision has a lot to do with your future income tax bracket, your age, your long-term goals for your IRA assets, and whether you can afford to pay the income and estate taxes from your other assets.
When Is It Better to Convert?
The following illustration demonstrates the difference between keeping a Traditional IRA vs. converting to a Roth IRA. In the scenario, Mrs. Wilson is 55 years old with a $2 million Traditional IRA. She has income from other sources and will not need the income from her IRA during her lifetime. Her two adult children will inherit the account when she passes away at age 85 in the year 2040.
In our example, if Mrs. Wilson makes the Roth IRA conversion, she will pay $700,000 in income taxes out of a non-IRA account. To make the comparison equal, her beginning value includes her Traditional IRA plus $700,000 of her other non-IRA assets. If she converts, she will use these assets to pay the income taxes; if she does not convert, she will keep these assets invested. As she does not need the income, she will invest the mandatory distributions from her Traditional IRA.
With a Traditional IRA, Mrs. Wilson’s minimum required distributions are triggered at age 70 1/2 and taxed at 43.4% (her assumed income tax rate during retirement). She will not need these taxable distributions during retirement and places the distributions in a non-IRA account. During her lifetime, she will pay $3.0 million in Federal income taxes on her IRA distributions.
When the assets from both the IRA and the non-IRA account (containing the distributions from her IRA) pass to her children, the children will pay $12.0 million in Federal estate taxes and $2.1 million in Federal income taxes. Their remaining after-tax assets will total $7.8 million.
Converting to a Roth IRA
If Mrs. Wilson converts to a Roth IRA, she will pay $700,000 in income taxes, assuming the 35% top Federal income tax rate in 2010. To maximize the assets remaining in her IRA, she pays these taxes out of a non-IRA account. There is no mandatory distribution requirement, so she will not take any distributions from the Roth IRA during her lifetime.
When the Roth IRA passes to her children, they will pay $12.3 million in Federal estate taxes. However, since no Federal or state income taxes will be due, the children will be left with $10.1 million in after-tax assets from the account.
Mrs. Wilson’s children stand to benefit significantly from the Roth IRA conversion. Since mandatory distributions are not required, Mrs. Wilson will be able to let the entire account grow tax-free during her lifetime. When her children inherit the account, the assets will be free of Federal and state income taxes. The total value of the inheritance will be nearly 30% higher than if Mrs. Wilson kept her Traditional IRA.
A Reversal Is Possible
If you are concerned that your account value will decline after you convert to a Roth IRA, you may reverse the conversion and recoup your tax payment, if you do so before October 15 of the following year. For example, anyone who converts between January and December 2010 will have until October 15, 2011 to reverse (or recharacterize) the conversion. If you choose, you may convert back into a Roth IRA at the beginning of the next calendar year, and pay income taxes on the presumably lower account balance.
Situations Where Converting to a Roth IRA May Make Sense
- You expect higher tax rates. Higher income tax rates in the future make tax-free Roth IRA distributions more valuable in cases where the tax impact on conversion does not outweigh the benefits of tax-free withdrawals.
- You have the ability to pay income tax and estate taxes from non-IRA funds. This allows more assets to grow tax‐free inside the Roth account.
- You do not need distributions from the IRA and would like to maximize benefits to heirs. Since there is no minimum distribution requirement for Roth IRAs, the account assets can continue to grow in the account until they are distributed income tax-free to beneficiaries.
- You would like to accelerate income into 2010. Converting to a Roth IRA is a way to accelerate the income you would be receiving from taxable IRA withdrawals in future higher-tax years, and paying those income taxes in a lump sum at this year’s lower rates.
- Your tax attributes are favorable. Taxpayers with special tax attributes, including a high basis ratio, charitable deduction carry‐forwards, investment tax credits or net operating losses may benefit because these attributes can reduce the effective tax rate of the conversion.
Watch for events that trigger a penalty. The following situations can trigger a 10% penalty:
- Funds are used from a Traditional IRA to pay the tax. Since these assets are not actually converted to the Roth IRA, they are considered a withdrawal, subject to penalty for account owners under the age of 59 1/2.
- Earnings are withdrawn within five years after the Roth IRA is established.
- Earnings are withdrawn before the Roth IRA owner reaches age 59 1/2.
Speak with Your Estate Planner, Tax Advisor or Fiduciary Trust Contact Today
The decision to convert should be based on your own unique situation and on careful analysis done by a financial professional. As of this writing Congress has not acted to revise the 2011 tax laws—however much can still change. If the scheduled tax increases are implemented, for those who could benefit, converting to a Roth IRA before December 31, 2010 may help to achieve maximum results.
We encourage clients to speak with their estate planner, tax advisor or Fiduciary Trust contact. Our expertise and sophisticated tools allow us to develop conversion scenarios based on your unique circumstances to help guide you in this important decision.
This communication is intended to provide general information. The information and opinions stated are as of August 23, 2010 unless otherwise indicated, and do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you.
IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
About the Author
Craig Richards, CPA/PFS, CFP
Managing Director and
Director of Tax Services
Craig Richards, CPA/PFS, CFP, is Managing Director and Director of Tax Services. He is a licensed CPA and CFP and is a member of the Officers' Executive Committee. Mr. Richards is a member of the New Jersey State Society of Certified Public Accountants and the American Institute of Certified Public Accountants.
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