Tax rates and taxes on investment income could rise after 2012. There’s the fiscal cliff of expiring tax provisions. Beyond that, there’s the likelihood that spiraling federal budget deficits and tax reform will cause higher tax rates on distributions from traditional IRAs.
That’s why in 2012 Roth IRA conversions are on the list of potential tax strategies of more people than any year except perhaps 2010. Under current law, a Roth IRA generates a tax-free stream of retirement income after a five-year waiting period.
Higher tax rates aren’t the only reason to consider a conversion. With a traditional IRA, required minimum distributions will increase over the years. RMDs can trigger higher taxes on your Social Security benefits, cause you to pay higher Medicare premiums, reduce tax benefits, and push you into a higher tax bracket. Roth IRA distributions avoid all that.
But a conversion is not for everyone. You need to balance a number of factors to make the choice that will generate the highest after-tax wealth for you and your loved ones.
When a traditional IRA is converted into a Roth IRA, the amount converted is treated as though it were taken as a distribution. All accumulated income and gains are included in gross income, as are any deductible contributions. Nondeductible (or after-tax) contributions won’t be included in gross income. The taxes are the cost of converting the IRA.
You need to balance the cost with the benefits. Here are the keys to your decision.
How long will the Roth IRA compound? Since it costs money to convert, you need time for the Roth IRA’s returns to compound and eventually make up for the early tax bill. My research over the years has shown a converted IRA needs at least seven years of compounding at an 8% annual return to make up for the taxes. It takes longer at a lower rate of return, and the minimum compounding period also depends on some of the other assumptions.
Where will the money come from? The conversion pays off fastest when the taxes are paid from non-IRA funds. If you don’t have enough outside the IRA to pay the taxes, you need very favorable assumptions for the conversion to pay off. If you use IRA funds to pay the taxes, you have to take a distribution equal to the conversion taxes plus an additional amount to pay the taxes on the distribution. So you need enough to pay the conversion taxes plus the taxes on that distribution. And if you are under age 59½, you’ll owe the 10% early distribution penalty on that distribution in addition to income taxes.
Will the tax rate change? This is the big reason many people are considering conversions now. It can be better to pay taxes today at a lower rate instead of a higher rate in the future.
What about state income taxes? This usually is not a major factor, but it could be a tipping point when you’re in a high-tax state, expect state income taxes to rise, or your state doesn’t exempt Roth IRA distributions from income taxes.
What will be the investment rate of return? The higher the return, the less time the Roth IRA needs to compound to make up for paying taxes early. The lower the return, the longer it takes to make up for the taxes. Someone who invests very conservatively and earns a low return might not benefit from a conversion.
How significant are other income and assets? The best case for a conversion is someone who has sufficient income and assets outside the IRA to maintain his or her standard of living. The IRA is an emergency savings vehicle and something to be left to heirs. Required distributions, which increase lifetime income taxes, won’t be imposed after conversion, so the IRA will compound undisturbed. In addition once inherited, distributions to the beneficiaries will be tax free and can be spread over their life expectancies. The conversion really is an estate planning tool and can be very effective. It won’t reduce estate taxes, but it will maximize the after-tax wealth of heirs.
How has the balance fluctuated? Ideally, you convert when the IRA is at a low point. Alternatively, it’s a good time to convert when you expect the IRA to grow in coming years.
Other factors. Remember a conversion might keep adjusted gross income low enough to avoid taxes on Social Security benefits, higher Medicare premiums, and disallowance of some tax benefits.
An IRA doesn’t have to be converted in its entirety. You can convert any part of the IRA in one year and convert additional amounts in later years or never convert the rest of your traditional IRAs.
You can change your mind. You have until Oct. 15 of the year after the conversion (if you file on time the return for the year of the conversion) to change your mind and reverse the conversion without any tax penalty. You’ll want to reverse the conversion (known as a recharacterization) if the IRA’s value declines substantially after the conversion date.
Because of the right to recharacterization, a good strategy is to convert an IRA by putting each asset into a separate Roth IRA. That way you can recharacterize those IRAs that declined in value and keep the others as Roths. Later, you can re-convert the assets that were recharacterized.
As you can see, there are a number of factors to balance. It is best to use a software calculator, or better yet, several of them. There are many free calculators on the web, but most do not let you change all the variables. Good ones are at www.bankrate.com, www.rothretirement.com, and www.dinkytown.com. Financial professionals use more expensive and robust calculators, such as the one at www.brentmark.com. Some people construct their own computer spreadsheets.
I built a calculator using an Excel spreadsheet that allows most variables to be changed. You can compare the results in a number of different scenarios. Check the web site at www.RetirementWatch.com for details about the spreadsheet.
RW November 2012.
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