Roth Conversions
Opportunity, or trap?
By John Sammut and RBC Wealth Management
A Roth IRA can be an attractive savings vehicle for a number of reasons, including tax-free qualified distributions and no required minimum distributions (RMDs) at age 70 1/2. To take advantage of these potential benefits, qualifying taxpayers can fund a Roth through annual contributions, rollovers of “Roth” assets from an employer sponsored retirement plan, or by converting a “traditional” IRA to a Roth IRA. With a Roth IRA conversion, any pre-tax assets that are converted to a Roth will be reported as taxable income, and will therefore generate an income tax liability. Up until Dec. 31, 2009, investors may convert IRA and other qualified assets to a Roth IRA only if their Modified Adjusted Gross Income for the year is $100,000 or less.
However, beginning Jan. 1, 2010, the $100,000 income ceiling for Roth IRA conversions will be eliminated. For Roth conversions made in 2010 only, the amount includible in gross income is permitted to be reported in equal installments over a two-year period, with half of the income reported in 2011, and the other half reported in 2012. Any tax incurred by conversions made after 2010 will be due in the year of conversion.
The fact that anyone will qualify to convert qualified assets to a Roth IRA doesn’t necessarily mean that they should. The following key questions can help evaluate whether converting to a Roth IRA might make sense for you.
Do you have funds outside of your IRA to pay the tax bill from the conversion?
It is best to use non-retirement assets for your tax bill generated from the conversion. If you tap your IRA to pay the “conversion taxes” and you are under age 59 1/2, not only will you be taxed on the conversion dollars, you will generally owe a 10 percent penalty tax on the distribution.
Is your IRA made up mostly of after-tax assets?
After-tax contributions are not taxed when converted to a Roth IRA. However, if your IRA contains both taxable and non-taxable assets, the amount you convert is deemed to consist of a “pro-rata” portion of the taxable and non-taxable dollars in the IRA. You cannot escape this result by using separate IRAs, nor can you convert only your non-taxable assets. You must aggregate all IRA accounts when calculating the taxes due on the conversion.
Can you handle the additional taxable income from the conversion without losing important tax benefits?
The conversion related income may push you into a higher tax bracket and potentially disqualify you from other tax benefits such as the dependent child and college tuition tax credits.
Have your retirement savings suffered losses due to market conditions?
It may make sense to convert depressed investments that are reasonably expected to increase in value over time, or experience rapid growth.
Do you have 10 or more years until you (or your heirs) need the money?
Generally, because of the tax consequences triggered by conversion, the shorter the time period before distributions begin from a Roth IRA, the less practical it is to convert.
Will you (or your heirs) be in a higher tax bracket when the money is withdrawn?
If you believe your income will be higher or that tax rates will be increased in the future, holding assets in a Roth IRA is more advantageous than in a pre-tax retirement account.
Will you need to withdraw money before age 59 1/2?
While it is generally not advised to take a distribution from any retirement plan prior to retirement, a Roth IRA does have some distribution flexibility. Five years (or later) after a Roth conversion, a taxpayer can withdraw the converted amount penalty and tax-free. Note that this does not apply to earnings in the Roth IRA, which can only be withdrawn without penalty and tax consequences under certain circumstances, known as qualified distributions.
Is your household income likely to increase significantly between now and retirement?
If you expect large income increases in future years, it may make sense to pay taxes on your retirement assets now before you step up to a higher tax bracket down the road.
Is most of your retirement savings in accounts that will be taxed?
A Roth conversion offers tax-management flexibility during retirement. However, if you have significant liquid assets outside of your retirement accounts you may already have the necessary flexibility.
Do you expect your taxable income in retirement to be higher?
This includes any type of income that would be considered ordinary income, including rental and pension income.
Paying taxes on a Roth IRA conversion now may effectively reduce your future tax liability in retirement.
Would you like to eliminate annual Required Minimum Distributions (RMDs)?
Unlike a traditional IRA, with a Roth IRA there are no required withdrawals beginning at age 70 ½, allowing for a significantly long time period of potential tax-free growth. Your beneficiaries gain tax free access to the Roth portion of their inheritance, though RMDs will eventually apply to them. Consequently, the Roth IRA is a very efficient tool for transferring wealth to future generations.
Would you like to reduce your taxable estate?
Paying income tax prior to the imposition of estate taxation may offer greater wealth to be transferred to your heirs, because no income tax deduction is permitted for state estate/death taxes levied on IRAs. Your taxable estate may also be reduced by the amount of income tax you pay on the conversion.
Other questions to consider: If you do decide to convert qualified assets to a Roth IRA, what percentage of assets should be converted? Also, does it make sense to spread the tax liability associated with the conversion over the tax years 2011 and 2012, or should the tax hit be taken all at once in 2010?
Clearly, the decision to convert is not an easy one. As with any major financial decision that involves tax considerations, you should consult with your tax advisor before converting traditional IRA assets to a Roth IRA. For additional information, including a conversion evaluator and calculator, feel free to visit http://johnmsammut.com and go to the link: “Roth IRA Conversion: Explore the Opportunity.”
John Sammut helps individual investors, families and corporations protect their purchasing power and improve investment results. You can reach Sammut by telephone at (800) 343-3036, or visit him at www.johnmsammut.com.
The opinions expressed in this report are those of the author and are not necessarily the same as those of RBC Wealth Management or its research department. RBC Wealth Management did not assist in the preparation of this report and makes no guarantees as to the accuracy or the reliability of the sources. This information should not be construed as a research report, as it is not sufficient enough to be used as the primary basis of investment decisions. Clients should work with their financial consultant to develop investment strategies tailored to their own financial circumstances.
RBC Wealth Management, a division of RBC Capital Markets Corporation, Member NYSE/FINRA/SIPC
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