Roth IRA Conversion
We have a fiduciary duty to act in your best interest. A Roth IRA conversion is a subject we should discuss to determine if it is a tactic that works with your personal financial strategy. If we choose to pursue, we will prepare a detailed analysis of the impact to your financial situation now and as it relates to the assumptions we make for the future.
There has been a lot of publicity on the newly legislated capability of high earners to convert traditional IRAs to Roth IRAs this year. It is certainly fodder for financial sales representatives to market to high net worth individuals. This can be a great alternative for those who believe they will have higher marginal tax rates in the future or those who wish to pass on a tax-free asset to the next generation. For the majority though, it is less of a sure thing. We are under the impression that the reason many financial professionals are recommending conversion is sales driven rather that what is in your best interests.
Beginning in 2010, anyone, regardless of age or income can convert traditional individual retirement account (IRA) assets to Roth IRA assets. Previously only those with less than $100,000 in modified adjusted gross income were eligible. A Roth IRA is appealing because earnings within the account are tax deferred and potentially tax free when relatively liberal conditions are satisfied. There is a catch though; a conversion is reported as taxable income with tax due at your highest marginal rate at the time of the conversion. The 2010 provisions allow for the conversion amount to be split and reported as income in the 2011 and 2012 tax years.
Benefits of a conversion vary based on assumptions we have to make now. There is no "one-size-fits-all" strategy. Analysis is required to determine whether potential benefits from conversion outweigh the costs.
Reasons to consider Roth IRA conversion:
1) You expect to be in a higher tax bracket later when you take withdrawals. Rates are scheduled to increase. Your expected marginal tax rate is a key assumption in the analysis. In general if your conversion tax rate is lower than your expected future tax rate you should proceed.
2) You have a long time horizon. Funds converted to a Roth IRA must be held in the account for at least 5 years or until you turn age 59.5. The longer funds can remain in the Roth IRA and grow tax-free, the better the economic result. Funds are more likely to remain in the Roth longer when the owner is younger or will not need the converted funds for living expenses.
3) You can pay the tax due from non-IRA funds. If you need the funds from the IRA to pay the tax you will lose the benefits of tax-free growth and may be subject to a 10% penalty if under age 59.5.
4) You have special tax attributes like a high basis ratio, charitable deduction carry-forwards, investment tax credits, net operating losses, or other items that may offset the income generated from the conversion and reduce your effective tax rate.
5) You wish to suspend required minimum distributions from your traditional IRA. The Roth IRA does not require distributions at any age so you have the ability to continue to defer earnings on a tax-free basis.
6) For estate planning purposes. You want reduce the size of your taxable estate. Assumes it is generally more advantageous to incur income tax before estate tax. Here you effectively pay tax in advance for your beneficiaries enabling tax free distributions that can be stretched over many years. This feature is of added benefit if the beneficiary will be in a higher tax bracket than the owner.
7) You believe assets in your IRA will appreciate in value. The higher the return the, greater the amount of earnings that escape taxation, and the better the economic result.
8) You have the ability to "recharacterize" the conversion. This allows you to undo the conversion if the Roth IRA goes down in value.
Just because you can it does not mean you should:
1) Conversion violates a general rule that you should not pay tax today that you can pay tomorrow. If the conversion did not make sense for you before 2010, it may not make sense in 2010 or later.
2) If you earn a high income you are already in a high tax bracket. Even though the rates are moving up, you may not be subject to higher tax brackets in retirement.
3) There could be other incidental costs to conversion since you would have to report the converted funds as income such as increased Medicare premiums or reduced financial aid.
4) Anticipated tax savings may not materialize due to factors out of your control like the tax law governing distributions.
You can make a partial conversion if:
1) You are unsure about your future tax rates.
2) Your RMDs bump you to a higher tax bracket.
3) Full conversion moves your current taxes too much.
4) You have insufficient funds to pay tax due on the full conversion.
The Roth IRA conversion has been called the planning opportunity of a lifetime. It is definitely something you should explore but should not be entered into lightly. Forrest Financial Services has the resources and experience to detail your tax and investing alternatives. Our analysis details the impact to your current tax liability. We model assumptions for future tax savings and investment growth as well as the impact to your estate and beneficiaries. Your input is critical and there is no right answer.
Pete Deacon, MBA, CPA, CFP®
Steve Forrest, MBA, CPA/PFS, CFP®