For the first time, many higher income earners may qualify for a Roth IRA conversion. Before 2010, you couldn’t convert a traditional IRA into a Roth in a year in which your modified adjusted gross income (MAGI) exceeded $100,000. But now, that income restriction has been eliminated. What’s more, though converting to a Roth results in income taxes on the amount you transfer, there’s a bonus for conversions made in 2010—you get to spread out the income and the resulting tax liability over 2011 and 2012. That not only delays some of the pain of paying for a conversion; it may also save you actual tax dollars, if the lower installment payments keep you from being bumped into a higher tax bracket and tax rates don’t increase significantly in 2011 and 2012.
There are good reasons to convert to a Roth. Qualified distributions from a Roth that has been established for at least five years are completely exempt from income tax. You’re eligible to receive this tax-free income once you reach age 59½, and qualified distributions are also possible in case of death or disability or to pay first-time homebuyer expenses (up to a lifetime limit of $10,000). And with a Roth IRA, there’s no rule requiring that the distributions must begin for holders of traditional IRAs after age 70½. So if you don’t need the money, investment gains in your account can continue to compound without being eroded by taxes until a non-spouse inherits the IRA.
Yet these advantages don’t necessarily mean you should immediately transfer all of the assets in your traditional IRAs into a Roth. There are numerous variables to consider, and it doesn’t have to be an all-or-nothing proposition. It could be beneficial to convert only a portion of your traditional IRA assets. Your answers to these questions could factor into your decision.
1. How will you pay the tax on the conversion? If the money has to come out of the tax-deferred assets you’re transferring, it will limit the benefit of the conversion.
2. What’s your tax rate? How much you pay now and your expected tax rates during retirement directly affect the conversion equation. While you might normally expect to be in a lower bracket during retirement—thus reducing the value of tax-free Roth income then—federal tax rates are scheduled to revert to higher levels in 2011 and even greater levies could follow for those in top brackets. State and local taxes may also increase.
3. Did you make nondeductible contributions to your traditional IRA? You won’t be taxed to convert the nondeductible contributions, but the earnings will be subject to tax.
4. How old are you and other members of your family? This affects how long assets will be able to grow in a converted Roth IRA—and the longer they grow, the bigger the tax advantage. If you have young children who might inherit the income tax-free assets, they may be able to spread out distributions (required after the account goes to the next generation) over many decades.
With all of these factors to consider, deciding whether to convert can be complicated. Suppose, for example, that you are 55, your spouse is 50, and your only child is 25. You have $500,000 in a traditional IRA and you’re in the 33% tax bracket. Assume you’re planning to convert to a Roth in 2010, you’ll elect the two-year schedule recognizing income and paying conversion taxes, and the money will come from outside your IRAs. The Roth IRA assets will earn 4% annually, and you intend to begin withdrawing $1,000 per month at age 70.
The Roth IRA Conversion Optimizer, a tool for wealth management professionals, shows that the optimal “net benefit” of this Roth conversion would be $1.19 million, assuming you transferred all of the traditional IRA’s assets.
But changing the scenario slightly results in a different outcome. Suppose you can pay only half of the conversion taxes with outside funds. In this case, converting 100% of the assets would provide a $725,000 net benefit. However, converting only 60% of the traditional IRA assets would produce a net benefit of $809,000.
If you don’t have any outside funds to pay the conversion taxes and instead use only the IRA’s funds, the net benefit of the Roth conversion greatly decreases. In this example, the benefit is only $231,000 for a 100% conversion and for a 60% conversion it’s $320,000. This demonstrates the importance of using outside funds to pay taxes and why a partial conversion can be ideal when outside funds are insufficient.
The variations can be mind-boggling, but you don’t have to crunch the numbers on your own. Give us a call and we’ll help you decide what works best in your situation.