To Roth, or Not to Roth: That is the Question

December 1st, 2010
by Jonathan Leidy

2010 marks a significant change in the rules for Roth IRA conversions, and with the 12/31 deadline rapidly approaching, a review of some of the key points is in order.

A Roth conversion is a process whereby an individual with a traditional IRA converts that account into a Roth IRA. Unlike traditional IRAs (which are pre-tax accounts), Roth IRAs are comprised exclusively of post-tax contributions. Hence, a conversion from traditional to Roth means recognizing any previously un-taxed IRA contributions as income in the conversion year. Both partial and total conversions are possible.

Two changes for 2010 have enhanced the accessibility and the attractiveness of a Roth conversion. The first is the removal of the income limit. Previously, individuals with adjusted gross incomes (AGIs) in excess of $100,000 were precluded from converting. Now anyone may convert, regardless of their AGI. The other change, introduced solely for 2010, is the ability to distribute the tax liability resulting from a conversion over the following two tax years, i.e. 50% of the conversion income will be recognized in 2011 and the remaining half will be recognized in 2012.

Naturally, the question for most investors is, “Does a Roth conversion make sense for me?”  The answer is “It depends.” The effectiveness of the strategy varies based on several key assumptions, namely future income tax rates and your expected income level at retirement.

Here are several situations for which a Roth conversion likely makes sense:

  • Higher Future Tax Rates: The number one consideration for a Roth conversion relates to the disparity between current and expected future income tax rates. Since all distributions from your traditional IRA will ultimately be taxed, whereas those from your Roth will not, it makes sense to convert assets if you anticipate tax rates will rise. Said another way, if tax rates were to remain exactly the same from now until the date of your ultimate IRA distribution(s), there would be no advantage to converting. Although predicting future tax rates is far from an exact science, current federal tax rates are historically low. Further, the trend is up, with both capital gains and ordinary income tax rates set to rise in 2011.
  • A Low Income Year: Any assets that you chose to convert to a Roth will be added to your AGI for 2010. So, in a low income year, you may be able to convert a portion of your traditional IRA, while taking advantage of lower marginal tax brackets. This scenario is most effective when you use cash in other accounts to pay the resultant taxes (see Paying Taxes with Outside Dollars below). Similarly, if you anticipate that your 2011 and 2012 income will be abnormally low, then executing a Roth conversion in 2010 and invoking the special tax “smoothing” option could be beneficial.
  • Required Minimum Distributions (RMDs): For traditional IRA’s the government mandates that you begin taking taxable required minimum distributions from the account (RMDs) once you reach the age of 70 ½. These forced distributions reduce the amount of money in your tax-sheltered account and hence, the overall potential for future compounded growth. If you anticipate that you will have a reasonable balance in your IRA at this age, you may be better off converting your IRA balances to a Roth today; it takes roughly 10 years for this RMD elimination advantage to manifest.
  • Estate Taxes: In rare circumstances, you can actually reduce your estate taxes by executing a Roth conversion. In particular, those individuals that have a small taxable account (in combination with the other taxable assets within their estate) and a larger tax-deferred account can execute a conversion and, in essence, swap reasonably high estate tax rates for their current marginal income tax rates. For more details on the nuances of this strategy, email us at info@porticowealth.com.
  • Paying Taxes with Outside Dollars: As noted previously, Roth conversions are most effective when the taxes are paid with dollars outside of the conversion account. By way of example, if you have a $500,000 traditional IRA that you converted, your Roth-equivalent balance (assuming a 30% tax rate) is $350,000. However, you are allowed to pay the $150,000 tax liability with monies from outside accounts. In doing so, you are taking money currently located in a less tax-efficient, taxable account and swapping it into your tax-advantaged Roth. All other variables equal, this trade-off will result in a higher overall net worth in the long run.
  • Tax Arbitrage: Having sources of both taxable and tax-free income in retirement allows for maximal flexibility. As such, it may make sense to convert a portion of your traditional IRA to a Roth in order to have the option to draw income from both taxable and tax-free sources in retirement.

Another notable characteristic of the Roth conversion is that it is reversible. In particular, if you convert assets and then subsequently experience a loss, you are entitled to “recharacterize” your contribution. Assuming that you execute this reversal prior to your tax filing deadline (including extensions), the conversion will be reversed and any impending tax liabilities will be eliminated.

The new rules related to Roth conversions have given investors a lot to consider. Although not always the case, many individuals will be able to benefit from making the switch. Feel free to contact us with any questions, and as always, we recommend you consult a qualified CPA or accounting professional before taking any action.