The Complexities of Roth Conversions

EDITOR'S NOTE: This is a revised version of an article originally published in the December 2009 issue of Kiplinger's Retirement Report. To subscribe, click here.

To Roth or not to Roth? With 2010 around the corner, that’s a question many of you may be asking. Come New Year’s Day, the $100,000 income ceiling to qualify for a Roth IRA conversion finally lifts. But just because you can convert to a Roth IRA doesn’t mean you should.

For retirees and those approaching retirement, the conversion decision hinges on a number of factors: your retirement-income needs, current and future tax bracket, life expectancy and legacy goals. The expected rate of return on your investments will make a difference, too. It is wise to run the numbers to see if converting at least some money to a Roth in 2010 makes sense.

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Roth IRAs have attractive features. Roth money can be withdrawn tax-free once certain conditions are met. Plus, account owners never have to take required minimum distributions, so the money can grow in the tax shelter for as long as you choose.

The downside: You have to pay income tax on the amount you convert. Usually, the tax bill comes due in the year of the conversion. In 2010 only, you can delay reporting the conversion for one year, and then split the converted amount in half on your 2011 and 2012 returns, paying part of the tax in 2012 and part in 2013.

When a Roth Conversion Makes Sense

A Roth IRA can be beneficial in the long term because of the power of compounded tax-free growth. The longer you can wait to tap the Roth, the more time the money has to grow tax-free. Converting assets that you won’t need to live on in the early years of retirement is generally more advantageous.

An analysis by T. Rowe Price considered a 65-year-old retiree who has a traditional IRA of $100,000 and $28,750 in a taxable account. All accounts grow at 6% a year. The retiree plans withdrawals of 4% a year, with 3% annual inflation adjustments. The analysis looks at two scenarios: converting and not converting.

If the retiree converts using his taxable account to pay the tax, after ten years the Roth provides about $500 less overall, after taxes, as compared with the nonconversion scenario. Converting is a wash because the Roth hasn’t had much time to grow tax-free. Also, the RMDs from 70 to 75 for the traditional IRA aren’t higher than the planned withdrawals.

But in this analysis, RMDs start to exceed planned withdrawals at age 77. From this age on, the traditional IRA starts to deplete faster than the Roth and converting starts to compare more favorably. By age 95, after taxes, the Roth conversion is worth more than the traditional IRA and taxable account by 10%, or about $27,000. Christine Fahlund, senior financial planner for T. Rowe Price, notes that the age at which the Roth conversion becomes more favorable can vary depending on factors such as tax brackets and market returns.

If you would otherwise be in the same tax bracket or a higher bracket in retirement, a Roth conversion could help keep your future tax liability in check. Roth distributions won’t boost your overall taxable income. Lower taxable income could make you eligible for certain tax breaks that phase out at higher income levels. Also, tax-free Roth distributions don’t count in the equation for taxing Social Security benefits.

For people who don’t need the IRA money to live on, converting can help free your IRA assets from RMDs. Perhaps you have pension payments and only need $10,000 a year in IRA distributions. If your RMD is $15,000, you could convert enough to keep your distribution at $10,000. And that lower RMD could reduce your tax bracket. “With required minimums, people lock into certain tax rates,” says Ken Kilday, a certified financial planner for USAA.

If your potential estate is hovering near the federal estate-tax exemption, converting to a Roth could eliminate or reduce your estate’s tax bill. The money you use to pay income taxes on the conversion will no longer be in your estate and that could help lower your estate below the exemption threshold. (Congress is expected to keep the federal exemption at $3.5 million.)

Heirs can benefit from a conversion in other ways. Although beneficiaries are subject to mandatory distributions on inherited Roths, they don’t have to pay income tax on the withdrawals. “An IRA is like a house with a mortgage. A Roth IRA is a house that’s paid off,” says Kilday.

Heirs can also stretch out the withdrawals from an inherited Roth IRA over their life expectancies. That would let the Roth grow tax-free for decades more.

If you convert early in 2010 and plan to pay the tax in 2012 and 2013, set aside the money in assets that won’t fluctuate much, such as a money-market fund or a fixed-income investment. “That money shouldn’t be invested in stocks,” says Lynn Mayabb, senior managing advisor with BKD Wealth Advisors, in Kansas City, Mo. If the account were to go down in value, you might not have the money when the tax is due.

When Not to Roth

If you plan to donate money from a traditional IRA to a charity, either while you’re alive or as a bequest, do not convert that money to a Roth. You would needlessly pay taxes, with no additional benefit for the charity. The tax bill on a traditional IRA is waived when the money goes to charity.

Also, if your motive for the conversion is to give tax-free money to your heirs, you may not want to convert if the beneficiaries are likely to be in a lower tax bracket when they get the money than you are now. You’ll pay more in taxes to convert than your heirs would have to pay if they inherited a traditional IRA.

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It may not make sense to convert now if you’re a preretiree and expect to be in a lower tax bracket after you retire. You may be in your peak earning years -- and in your top bracket. You could end up paying less tax overall by waiting until you’re in a lower bracket.

Consider the state-tax burden, too, if you’re planning to relocate in retirement, says Diane Young, director of retirement and goal planning for TD Ameritrade. You may want to hold off on converting if you’re moving from a high-tax state to a low-tax state.

Also, paying the tax bill out of IRA assets will foil the goal of tax-free growth. Bryan Hopkins, president of Hopkins Wealth Management Group, in Anaheim Hills, Cal., offers this example: A 55-year-old couple has a traditional IRA of $500,000 that earns 7% a year for ten years, growing to about $1 million. That allows them to take out $71,000 a year, providing them about $60,000 of net income after paying $11,000 in taxes. At a 5.5% annual rate of return in retirement, Hopkins says the money would last about 27 years.

If that same couple at 55 converts the entire IRA to a Roth, and they pay $177,000 in taxes from the IRA, they would have $323,000 left to invest for ten years. The money would grow tax-free to nearly $650,000 and would last about 16 years.

You can strike a middle ground and only convert money for your later retirement years. Say you have a $1 million IRA. If you need $500,000 of it for the next ten or more years, keep that money in the traditional IRA. Using outside assets to pay the tax bill, you can convert the balance to a Roth and let it grow tax-free for late retirement or for your heirs.

The Timing of a Conversion

If you decide to convert, it’s important to be up to speed on some basic rules. The two biggest factors: age and length of Roth ownership.

Account owners who are 59½ or older can withdraw converted amounts penalty-free at any time. Those who are younger pay a 10% penalty if they withdraw converted contributions within five years of the conversion; each conversion has its own five-year holding period.

You must have had a Roth for five years and be 59½ or older before you can withdraw earnings tax-free. (Younger account owners are also subject to a 10% penalty on withdrawn earnings.) If you convert in 2010 and the conversion is your first Roth, you can withdraw earnings tax-free in January 2015, if you are 59½ or older at the time of withdrawal. If you are converting but have already had a Roth for five years and are 59½ or older, you can tap earnings tax-free from any of your Roths.

For those who are younger than 59½, staggering conversions over several years staggers the dates the converted amounts can be tapped penalty-free. For instance, a 2010 conversion is penalty-free in 2015 and a 2011 conversion is penalty-free in 2016. But once you hit 59½, and you’ve had a Roth for five years, you can tap any of the money tax- and penalty-free.

You’ll also need to figure out the impact on your tax bill in the year you convert. A very large conversion could throw you into the top tax bracket and hand you a hefty tax bill. Doing a partial conversion instead would minimize the tax hit.

A smart strategy is to convert enough every year to take you to the top of your current tax bracket. For 2010, the 25% tax bracket for those married filing jointly is $68,000 to $137,300. So if your taxable income is $100,000 in 2010 and you decide to pay the tax on your 2010 return, you could convert up to $37,300 and stay in the 25% bracket. Convert $40,000 and you’ve hopped into the 28% bracket. (If tax brackets stayed the same and you chose to defer and split the tax bill, you could convert up to $74,600 in 2010 without jumping brackets.)

Deferring the tax bill and splitting the converted amount over your 2011 and 2012 returns could keep you in a lower tax bracket. But you need to consider future tax rates. Without Congressional action, tax rates are scheduled to rise in 2011. For instance, the top tax bracket is slated to rise from 35% to 39.6%. High-incomers may want to elect to pay all the tax on the conversion in 2010, instead of deferring and splitting the tax bill.

For example, if you’re in the top tax bracket and plan to convert $150,000, you’ll owe $52,500 if you convert in 2010 and pay all the tax on your 2010 return. Wait a year and split the conversion over two years, and you’ll pay $59,400 if rates rise.

The good news is you don’t have to decide when to pay the tax until you file your 2010 tax return in 2011. By that time, tax brackets and rates for tax year 2011 should be clearer.

In 2010, Kelly Campbell, principal of Campbell Wealth Management, in Fairfax, Va., recommends converting “earlier in the year rather than later.” With the economy recovering, the value of an IRA invested in stocks could be higher in December than January. Your tax tab would be higher as well.

You can test whether a Roth conversion might be for you with an online calculator, such as Should I Convert My IRA to a Roth IRA? If an online calculator suggests that a conversion may be appropriate, consult a professional who can take a closer look at your specific situation before you pull the conversion trigger.

Keep in mind that you don’t have to liquidate an IRA to convert it. Instead, says Daniel Deighan, founder of Deighan Financial Advisors, in Melbourne, Fla., you can conduct an “in kind” transfer of your investments from your traditional IRA to the Roth IRA. That way you won’t incur any commission and transaction costs from selling and then buying investments again.

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