Saving for Retirement
How to Finance a Roth Conversion
Making the switch to a Roth makes sense for some, and there are plenty of ways to pay the tax bill.
By Mary Beth Franklin, Senior Editor
From Kiplinger's Personal Finance magazine, March 2010
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OUR READERS
Nathan and Stacey Zee
Arlington, Va.
Should we borrow to pay the tax on a Roth IRA conversion?
Nathan and Stacey, federal workers in their thirties, are excited about the prospect of transforming their already sizable IRAs into tax-free retirement income. But the price could be steep. It will cost about $100,000 in federal and state taxes to convert the $250,000 they have stashed in their traditional IRAs to Roth IRAs this year, when income limits on conversions disappear.
The Zees are thinking about borrowing on their home equity to pay the taxes. Is that wise? And when should they pay the tax bill? Nathan and Stacey know that if they report the entire conversion on their 2010 return, the extra income will boost them into the maximum 35% federal bracket. Their alternative is to use the one-time opportunity to split their tax bill between their 2011 and 2012 returns.
Think it through. Anthony Christensen, president of Access Wealth Management, in Louisville, Ky., says the Zees should definitely convert all their IRA money to Roths. “The Roth IRA is almost the only way to earn tax-free money without going to prison,” quips Christensen. But he doesn’t recommend that Nathan and Stacey, who have an infant daughter, Rachel, leverage their future to do so.
Because the Zees have two incomes and prodigious savings habits, Christensen thinks they could pay the tax out of current cash flow. If they set aside $2,000 a month and defer the first tax payment until their 2011 return, they could have $56,000 (before interest and taxes) saved by April 2012, the due date for their 2011 tax return. That’s more than enough to pay the first half of the tax bill.
Christensen thinks it would be better to risk paying a bit more if tax rates go up than to draw $100,000 on a home-equity line at a variable interest rate (recently 4.5%), even though the interest would be tax-deductible.
Another view. Mitch Drossman and Lester Law, wealth strategists for U.S. Trust, Bank of America Private Wealth Management, think Nathan and Stacey should convert a little of their traditional IRAs to Roths each year, paying the tax as they go, without mortgaging the house or draining their savings. “We don’t think they need to rush into this,” says Drossman. “They’d be giving up a heck of a lot of flexibility to do it all at once.”
But even if the Zees decide to convert all their IRA money to Roths in 2010, they have until October 15, 2011, to change their minds. At that point, it should be clear what Congress intends to do with future tax rates, says Law, and they can decide whether to report all the income from their conversion on their 2010 return or split it between their 2011 and 2012 returns.
That same grace period offers them an extra safeguard in the event the value of their IRAs falls below the level when they converted in 2010. Rather than paying tax on the higher, phantom value, they can undo the conversion without owing any tax and reconvert sometime in the future.
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Reader Comments (13)
Posted by: Michael Broder, MD at 02/04/2010 08:42:38 PM
This article repeats a fallacy regarding Roth conversions in the last 2 paragraphs. Undoing a Roth conversion WILL NOT save taxes if the value of the investment falls. For example, if a $100,000 IRA (in a certain mutual fund) was converted to a Roth (in the same fund) in January 2007, it would have been worth about $60000 on Dec 31st 2007.. You can only reconvert to the IRA the $60,000 since the $40,000 was "Lost" as of that date. You still have converted that $40,000, which is taxed as ordinary income, and must pay the tax (added to the rest of your income). The 40,000"loss" is the same as if you had left it in that IRA. No matter how you try to recalculate this the result is the same. The process converts money from your IRA to ordinary income for tax purposes. It only allows you to place it In a ROTH IRA conversion for future tax savings. In the case of this couple, the only sensible option is to convert slowly over a period of years so that their tax liability is low, they use dollar cost averaging, and not market timing. Certainly borrowing any money to do this is risky and not cost efficient. In any case, Roth IRAS are only worth while if you are certain that your tax bracket after retirement will be less than it is for each conversion. Can anyone really be certain of that? I have done some conversion, to reduce the mandatory payout from my IRA at 70 1/2
Posted by: MARTHA L at 02/09/2010 11:07:51 AM
One way for older folks (nearing 70) to do a tax free Roth conversion is to repay Social Security and reapply for higher benefits. Part or all of the money repaid may be used as a itemized deduction to offset the income produced by the Roth conversion. It may be possible to make a totally tax free Roth conversion using this idea. If you want / need to borrow money to pay for this repayment, the higher Social Security benefits should more than offset the loan payments if you can get a fixed low interest loan. You also get additional inflation protection from Social Security as an added bonus. This idea is complicated and should be run by a competent financial advisor before trying to implement.
Posted by: Gnatman at 02/11/2010 09:47:17 AM
I prepared a calculator that uses the current tax rate and income thresholds and it performs the tax calculation into the future for each year. So, I can assume any year of conversion but we all know that 2010 is the only time period for the all important 2 year splitting of income. It shows by manipulation of income amounts that sometimes it is necessary to convert less than full account amounts to ensure that you fall into smaller tax brackets in those 2 years - don't assume the 2 year split will net a lower rate. I also added to the calculations the IRA required minimum distribution RMD dates and amounts. This is to form a comparison of the effect of conversion vs no conversion. Adding Future Value computations to the difference in tax in conversion year or years vs the expected tax increase stream over the RMD period. This showed me that the ROTH conversion is almost always more costly - the only exception would be that your intention is to never touch the ROTH and leave it to a next generation.
Posted by: j at 02/12/2010 09:16:45 AM
Mr Broder, dont give advice if you are not qualified to do so. Recharacterizing the conversion will fully eliminate that tax burdern. It does not leave the 40k in income. If that were the case the "recharacterization" would have 0 purpose.
Posted by: Dan Thomas, CPA/PFS at 02/12/2010 02:38:11 PM
Michael Broder, MD: Stick to giving medical advice. The article is correct and you are wrong. You don't understand the Roth rules correctly and should seek out a CPA/PFS who has the expert knowledge of this subject to help you out - it appears you need it. For most people, Roth conversions should only be done under the supervision of a qualified tax professional.
Posted by: kevin mccormally at 02/12/2010 04:51:41 PM
Kevin McCormally of Kiplinger here with a comment about the comments left by Michael Broder. Whoa! I'm afraid you've got the recharacterization thing all wrong. We have it right. If you convert $100,000 to a Roth, you report $100,000 in income. And, if by October 15 of the year following the year of the conversion the account has fallen to $60,000, you can recharacterize the account back to a Roth. Sure, you only have $60,000 in the traditional account, but you remove the full $100,000 from your taxable income for the year of the conversion. You don't have to pay tax on the $40,000 of disappearing income. Second, I take issue with your comment that Roth conversion only make sense if you're sure you'll be in a lower tax bracket after retirement than at the time of the conversion. I suppose Dr. Broder meant to say the opposite, that it only makes sense if you'll be in a higher bracket (so that you had paid tax at a lower rate). That's what lots of folks think. But, in fact, a conversion can make sense even if you find yourself in the same or a lower bracket. Not for everyone, but for some taxpayers. Roth IRAs have no mandatory distributions at any age for the original owner, payouts are tax free, payouts can't force Social Security benefits to be taxed or trigger other income-level tax penalties, and, anything left in a Roth when you die goes to heirs tax free.
Posted by: JoeTaxpayer at 02/12/2010 08:10:12 PM
Sorry, Anthony, I disagree with the wholesale conversion. The article doesn't mention their current taxable income, but I only surmise that you have a bid more data than we readers. Somehow you know that as government employees they appear to be on track to have pensions that nearly replace their income 80-100%, so even before they take retirement money, they are already in a high bracket? If so, your advise makes more sense, but prompts my question - how can you make such a large bet that this couple will have no life changing events? One or the other stopping work for a time, whatever the reason, will drop their bracket, and the conversion can "top it off" for those years. You know that in today's dollars, it would take over $2M in pretax money to create a retirement withdrawal high enough to even fill the 15% bracket. If they don't have the remarkable pension I wish for them, it would take decades of serious savings to keep up with that inflation adjusted $2M. Without knowing their exact bracket today, I'd suggest they "top off" their current bracket by converting just enough to do so. If they are at the top of the 25, I'd not argue to convert a bit each year into 28. The shame of all this conversion talk is for those who find that 20 years hence are in a low bracket and paid while working at higher rates.
Posted by: Scott at 02/14/2010 03:17:19 AM
Dr. Broder's comments are typical of most doctors...because they are so brilliant in their field, they assume the brilliance translates to other fields. Yet docs are too often terrible money managers and even worse investors. Whether you are a doctor or not, if you are not a LICENSED tax professional, seek advice before deciding how to handle your IRA this year. I'm a licensed financial advisor and I'm consulting with my CPA and my clients' CPAs before making any decisions on Roth conversions.
Posted by: Peter Ruizzo at 02/15/2010 12:32:27 PM
My simple conclusion is ----Invest the $100,000 that would have gone for Taxes in a Municipal Bond Fund. The Annual $5,000 income is TAX FREE. (Yes the article says Roth's are the only tax free route--WRONG!) That $5,000 extra tax free Annual income will more than offset any taxes due on the IRA future earnings in my opinion. Taxpayer would draw out their regular minumum distributions from the IRA at much lower rates than lumping now over just 2 years deferral.
Posted by: Nathan Zee at 03/09/2010 07:51:06 AM
As the subject of the article, I want to add our perspective. While we agree that the business case on the dollars converted is not clear given all uncertainties over the next 30 years as far as future tax rates versus opportunity cost of capital, etc., the end driver for us was the ability to effectively contribute to a Roth IRA moving forward even though we exceed the income limits for directly contributing to a Roth. We'll contribute to a Traditional IRA and immediately convert to a Roth every year as long as the tax law permits it. Although the lack of required minimum distributions, no impact on income for taxing social security, and tax free inheritance are current benefits, we're not counting on these in 2040. Although I believe our effective tax rate in the future we'll be about the same as it is today given our projected retirement income (unfortunately the pension is not 80-90% anymore - it would be 30% max which is still an excellent deal no doubt). If we convert a little at a time capping off at our current tax rate, we will not be able to effectively contribute to the Roth with new IRA contributions. When the Federal government Thrift Savings Plan (401k equivalent) allows Roth contributions in a few years, we will NOT take advantage of this due to many of the points made here. However, converting our IRAs now gives us a conservative net benefit of well over $300K, so we went for it. Now, the aggressive saving for the tax bill begins!
Posted by: Peter Russo, CPA at 03/11/2010 05:58:36 PM
TO THE ZEEs: Sorry to see you made what I label a compulsive decision. But, you should have had an Advisor who is also Tax experienced. This Decision requires much tax expertise along with a reasonable assumption expertise. Almost all my clients have been guided to defer their taxes for as long as they can. Tax laws have changed over 36 times in the past years. No reason to assume this time is the best. Your decision to do conversion is the same as Giving the Govt back ALL your IRA deduction benefits based on a "Start Fresh attitude." You were in the lead by ten touchdowns--now you just start the game from scratch waiting for the next Govt. betterment...I just don't believe you will come out ahead. Conversions are a game for sales-advisors and there is an article in Investment Advisor Magazine which fully explains WHY your decision is not suggested.
Posted by: Louise at 04/11/2010 12:34:38 AM
I am in my mid thirities and want to open my first IRA. I am not sure if a Traditional or Roth IRA is a better choice. Not sure what information about myself you need to know to make that choice. But I am in the 25% tax rate and I'm currently unemployed. Going back to school to become a registered nurse and plan to start working as a nurse at the end of the year making around 50K a year. Also what financial company offers some of the best mutual funds to invest in? Vanguard, T. Rowe Price, Putnam or Fidelity? Thanks.
Posted by: JoeTaxpayer at 07/11/2010 09:49:48 PM
Peter -I agree with you. You seem to be the voice of reason in this discussion. I don't know what Nathan meant about "If we convert a little at a time capping off at our current tax rate, we will not be able to effectively contribute to the Roth with new IRA contributions." Of course he could have. You can still deposit to an IRA and if it wasn't deductible, you have a tiny bit of math to perform, as some percet of your IRA holdings are not to be taxed again. I am really concerned at how many people have been convinced that wholesale conversion makes sense. I imagine it will benefit very few people. Should Nathan and Stacey ever find they are unemployed (by force or choice) they will have missed the chance to convert at a lower rate. I am working with an 80 yr old to convert the exact amount each year to top off the 15% bracket, not a penny more. She and her husband were in the 25% bracket while working. In the original article, Mitch got it right.