Roth IRA Conversion-Opportunity is Knocking

While I am not a distrusting person, I find the strength my reliance on “advice” often is inversely proportionate to the degree of my perception that the advisor stands to gain only when I take action in reliance. Accordingly, since I am not selling anything, I have no financial interest in your (or your clients) decision. But I am writing, nonetheless, to alert you to what some call “the planning opportunity of the decade”.

As you may know, and as many investment advisors are currently publicizing, effective January 1, 2010, due to a “revenue raiser” in the Tax Increase Prevention & Reconciliation Act of 2005 (“2005 Tax Act”), Congress removed the income limitation from the requirements for eligibility to convert an existing IRA to a Roth IRA. Similarly, recent Congressional action permits conversions from other qualified tax-deferred plans, such as 401(K), 401(b) or Simple IRA accounts. Prior to 2010, to be eligible your modified adjusted gross income (namely, all of your taxable income, less certain tax-favored deductions and less the taxable amount of any pension/IRA converted) for the year of the conversation could not exceed $100,000. On Long Island, few were eligible due to the income limitation because of the number of two wage-earner families.

Since 1998 Congress has authorized taxpayers with earned income (if their modified AGI is under $176,000 married/joint or $120,000 single for 2009) to invest for retirement (up to $5,000 for 2009 or $6,000 if 50 or older) in "Roth IRA's".  Unlike regular IRA accounts, Roth IRA's are always paid with "after-tax" money, and suffer from many of the same restrictions on withdrawals of account earnings before age 59? (however, Roth contributions may be withdrawn tax-free at any time).  Like a regular IRA, the account earnings grow tax-free during your lifetime and, upon your death, withdrawals must be taken by a non-spouse beneficiary at least at the prescribed rate over their lifetimes.

However, the Roth has a number of critical advantages compared to a regular IRA:

1. Once you have the Roth for 5 years and attain age 59?, you (or your beneficiary) may withdraw the entire Roth IRA account (your contributions plus the growth) completely income tax-free.  Regular IRA withdrawals are subject to income tax, except that any non-deductible contributions made to the account may be withdrawn over the life of the account on a tax-free basis.

2. Once you attain age 70?, the Roth IRA account is not subject to the "Required Minimum Distribution" rules applicable to regular IRA's and pension accounts, so it can continue to grow tax-free to maximize the amount available for either your retirement or for your beneficiaries.  Only when you die and the Roth is left to a non-spouse beneficiary must withdrawals begin.  While beneficiaries are subject to required minimum distributions, those distributions are income tax-free. 

3. You can continue contributing to the Roth (if you otherwise qualify and have earned income) even after age 70?.

While qualifying taxpayers may contribute annually to a Roth account, such annual, systematic contributions can create a nice, tax-free, nest egg over time. However, the annual contribution strategy is not the "home-run" that a conversion of an existing IRA can be due to the vast sums many people have already amassed in regular IRA accounts, whether as a result of lifetime accumulation or as a result of a roll-over of a pension upon the termination of prior employment.

Since there will be income taxes owed on the taxable amount of any account converted, the cost of the conversion should be carefully weighed against the potential benefits to be derived. While the "up-front" tax payment on the conversion is the biggest obstacle for most people (consistent with the general tax advice "never pay any tax that you can defer until a future date"), it would better to view it instead as “the cost of the investment”- parting with some money now, while painful, to permit practically limitless Roth growth to accrue for the benefit of your family on an income tax-free basis, in the right situation. In most cases, the benefits of the Roth conversion will outweigh the immediate out-of-pocket income tax cost, with the greatest benefits being obtained by those who can leave the funds in the Roth account for a greater amount of time.  Why?  Because unlike a regular IRA, all of the growth in a Roth account may be withdrawn tax-free.

While every person’s situation is unique, a few generalizations concerning Roth conversions can be made:

1.      The longer the money can be left in the Roth account, the greater the tax-free withdrawals.

2.      If the Roth IRA funds will not be required until later in retirement, the greater the advantage of the Roth conversion.

3.      If saving for the next generation is a goal, the Roth is significantly better due to the lack of “required minimum distributions”;

4.      If the funds are needed within the next five years, do not consider converting.

5.      If the money needed to pay the income tax on the conversion will come from the IRA, the advantage of converting will be reduced/eliminated.

With respect to the income tax caused by the conversion, a special provision of the 2005 Tax Act permits people who convert in 2010 to pay one-half of the tax in 2010 and one-half in 2011. Once the up-front tax on the conversion has been paid, the Roth IRA can grow with no further tax on growth or on withdrawal, and there is no requirement to withdraw the funds during your lifetime, permitting longer, tax-free growth for the benefit of the family. 

While the Roth will be included in your taxable estate, and subject to any applicable Estate taxes, the funds may be withdrawn tax-free so there will not be an income tax cost if the Roth is needed to pay the Estate tax (compared to the immediate income tax impact on any withdrawal of taxable pension funds to pay the estate tax).

 While all the reasons discussed above should justify the conversion, the "cherry-on-top" is that, if your estate may have an Estate tax liability, the "up-front" income tax cost of the conversion reduces your taxable estate by the amount of the tax paid.  The result (assuming a 50% aggregate federal and New York State estate tax rate) is that your Estate's estate tax liability will be reduced by 50% of the income tax paid. Accordingly, if you expect to have an estate that will have a federal estate tax liability, a "death-bed" conversion is a sound strategy for maximizing the family's financial benefits.

As with all such financial plans, I encourage you to discuss with your financial advisors whether a Roth conversion is right for you. While I have not seen any “calculators” available to quantify the benefits of a Roth conversion (most likely because of the uncertainty of the assumptions involved, such as the federal and state income and estate tax rates, and the complexity of every person’s personal situation), please feel free to contact me to discuss any questions on any of the foregoing, or any other aspects of the Roth conversion.