Preparing for the Roth IRA Opportunity
In 2010 all taxpayers will have the opportunity to create a tax-free stream of retirement income by converting traditional IRAs into Roth IRAs – and can receive a tax incentive to convert. Most Baby Boomers aren’t even aware of the upcoming conversion opportunity, and only a minority plan to convert, according to recent surveys. That’s too bad, because converting to a Roth IRA can increase retirement cash flow for many people.
In this visit, we review the 2010 Roth IRA opportunity and the factors to consider when deciding whether or not to convert.
The Roth IRA basics are well known. No deduction or other tax benefit is available for setting up a Roth IRA. All income and gains earned by the Roth are tax free. Most importantly, distributions from the Roth IRA are tax free if they are taken the later of five years after the owner opens any Roth IRA and the owner attains age 59½.
Another advantage of the Roth IRA is there are no required minimum distributions for owners over age 70½. In addition, when a non-spouse inherits a Roth IRA, distributions are tax free whether the entire IRA is withdrawn or distributions are taken over up to five years or spread over their life expectancy.
A traditional IRA can be converted into a Roth IRA. Until Jan. 1, 2010, only taxpayers with adjusted gross incomes below $100,000 are allowed to convert traditional IRAs to Roths.
There is a cost to converting a traditional IRA to a Roth IRA. The amount converted is treated as though 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. So, there is a tax bill to pay when converting.
There is an incentive to convert IRAs in 2010. For amounts converted next year, the IRA owner has a choice of when to pay the taxes. They can be paid with the 2010 tax return, or they can be deferred and paid in equal shares in 2011 and 2012. There is no interest on the deferral, so it is a gift from Congress to encourage conversions in 2010.
Note the deferral of taxes on 2010 conversions applies whether your income is above or below $100,000. Also, though the deferral is limited to 2010, the removal of the $100,000 limit is permanent.
You might ask: Why wouldn’t a taxpayer want to delay paying the taxes? One reason is the taxpayer has a lot of deductible expenses or losses on the 2010 return that will shelter the conversion income. Another reason is the taxpayer expects to be in a higher tax bracket in 2011 and 2012.
Suppose a married couple each convert their IRAs. Can they choose separately whether to defer the taxes? That isn’t clear from the law or regulations issued to this point. I assume they can, but we won’t know until the IRS issues guidance.
Those are the rules. The issue is whether converting is a good idea for you. There is no one answer. The best choice depends on several factors and assumptions. 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. The minimum compounding also period depends on some of the other assumptions we review.
Where will the money come from? The taxes should be paid from non-IRA funds. If you don’t have enough outside the IRA to pay the taxes, you probably shouldn’t convert. If you use IRA funds to pay the taxes, you have to take an additional distribution from the IRA to pay the taxes, and if you are under age 59½ will owe the 10% early distribution penalty on that amount in addition to income taxes. (Converted amounts are not subject to the 10% penalty.)
An IRA does not have to be converted at once. If you don’t have enough cash to pay the taxes, you can convert part of the IRA. You will miss the 2010 tax deferral option for any amounts converted after 2010, but you will be able to convert the entire IRA in stages.
Will the tax rate change? If you expect to be in a higher tax bracket in the future when you might be taking distributions from a traditional IRA, it is better to pay taxes today at the lower rate. In the rare case you will be in a lower bracket when distributions begin, it might make sense to keep the traditional IRA and defer the taxes.
What about state income taxes? Some states treat the Roth IRA the same as the federal government does, but others tax Roth IRA distributions. This usually is not a major factor. But if conversion is a close case and the state will tax Roth distributions, a conversion might not be worthwhile.
What will the investment return be? 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.
How significant are other income and assets? Some people have sufficient income and assets outside their IRAs to maintain their standards of living. For them, the IRA is an emergency savings vehicle and something to be left to heirs. In this case, conversion often is a good idea. 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. In this case, the conversion is more of an estate planning tool than anything else, and can be very effective. It won’t reduce estate taxes, but it will maximize the after-tax wealth of heirs.
How much of Social Security benefits will be taxable? More and more retirees are paying income taxes on their Social Security benefits. Converting a traditional IRA to a Roth IRA might reduce adjusted gross income enough to lower or eliminate taxes on benefits.
Will the IRA’s value increase? You pay income taxes on the IRA’s value on the day of the conversion. Many IRAs are below their peak levels, so conversion now or in 2010 is a bargain compared with a few years ago. A conversion now or in 2010 also might be a bargain compared with the value a few years from now if the markets recover. But if there is a correction after you convert, you will want to reverse the conversion, which we discuss shortly.
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.rothretirement.com, www.dinkytown.com, www.-volition.com, and www.datachimp.com. (Ignore the hyphen.) Financial professionals use more expensive and robust calculators, such as the one at www.brentmark.com. Some people construct their own computer spreadsheets.
You can pay taxes on your IRA now through a conversion to a Roth IRA or you can pay later as distributions are taken from the traditional IRA. To encourage you to pay sooner rather than later, next year you can spread that conversion payment over three years to increase the benefits of a conversion.
Congress is not likely to do away with the special conversion rules for 2010. The conversion is scheduled to bring a lot of money into the treasury, so changing the law would be very expensive for the government.
Remember a conversion can be reversed (known as a recharacterization) through Oct. 15 of the year following the conversion if your tax return is filed on time. For example, if you convert in 2010, you have until Oct. 15, 2011 to reverse the conversion. There is no tax cost to reversing the conversion, especially if you elected to defer taxes on a 2010 conversion. You may want to reverse a conversion if the value of the account declined after the conversion. You can do another conversion later. We discussed recharacterizations in more detail in past visits, and those discussions are in the Archive on the members section of the web site for your review.
RW October 2009.
