Roth IRAs, despite their attractive features, have yet to match the popularity of traditional IRAs. As of 12/31/08, $3.5 trillion was invested in traditional IRAs compared to $165 billion in Roth IRAs. One main reason why Roths constitute such a small percentage of total retirement assets is that high net worth individuals – who potentially stand to benefit the most from them – have been ineligible to contribute directly to one or convert their existing traditional IRAs to a Roth.
Starting in January 2010 the income ceiling for Roth conversions is eliminated. This presents an interesting dilemma for individuals who can afford the conversion: convert now and accelerate taxable income, which breaks a general cardinal rule of paying tax before it is due. On the other hand, a Roth IRA, unlike a traditional IRA, would enable both tax-free withdrawals and the avoidance of the required minimum distribution (RMD) rules– allowing more wealth to accumulate tax-free for a longer period of time. The Roth conversion analysis is a decision that involves paying taxes now vs. the opportunity to grow wealth tax-free for a longer period of time.
Although conversion to a Roth IRA does trigger immediate taxable income, Congress provided a special incentive in 2010 to jump-start Roth conversions. In 2010 (and 2010 only), individuals will have the choice of recognizing their conversion income in 2010 or averaging it over 2011 and 2012. The latter option, which must be elected, allows you to pay taxes on the converted amount ratably over two years, instead of recognizing it all as income in one year. You will be taxed at the rates in effect for 2011 and 2012.
For some taxpayers, their tax rate may rise after 2010 even if their income does not. President Obama has proposed, and Congress is expected to enact, legislation to restore the top two pre-2001 marginal income tax rates after 2010. This means that the top two brackets could be 39.6 percent and 36 percent after 2010. There is the option to pay the full tax on the Roth conversion on your 2010 income tax return, at 2010 income tax rates.
An IRA to Roth IRA conversion should be considered by individuals who:
- Can afford the tax on the converted amounts;
- Anticipate being in the same or higher tax bracket in the future than they are currently in;
- Have a significant amount of time before reaching retirement to allow assets to grow tax-free and recoup dollars that may have been lost due to the conversion tax;
- Anticipate a taxable estate; and
- Wish to grow assets tax-free and leave assets to children who could take tax-free distributions over their life expectancy.
Convert Nondeductible IRAs?
Individuals who have nondeductible IRAs (or a mix of nondeductible and deductible) can convert and pay little or no tax. Nondeductible IRAs are not taxable when converted to Roth IRAs if the account holder has no appreciation in the IRAs and doesn’t own deductible IRAs. For example, a married couple, ineligible to contribute directly to a Roth IRA and with no existing IRAs can contribute $5,000 each to a nondeductible IRA for 2009 and 2010. Then, the next day they can convert the nondeductible IRA to a Roth IRA. The result is a transfer of $20,000 in taxable assets to a Roth IRA which will never again be subject to income tax if certain holding requirements are met. Individuals with a mix of deductible and nondeductible IRAs must prorate the conversion, so regardless of which specific account or amount they convert, part will be treated as taxable and part as nontaxable. For example, an individual has $100,000 in a deductible IRA and $50,000 in a nondeductible IRA. If that individual were to convert $30,000 to a Roth IRA, he would recognize $20,000 of taxable income on the conversion (100,000/150,000 * 30,000).
Roth Redo: A Money-Back Guarantee?
If you’re not satisfied with your conversion, you may want to take a mulligan. With Roth conversions, you can. For example, say Jack, a 60 year old individual with a combined 45% effective tax rate converts $1 million from a traditional IRA to a Roth IRA on January 15th, 2010, resulting in a $450,000 tax liability. He proceeds to watch the value of his Roth IRA decline by 25% to $750,000 over the next 21 months, as a result of poor investment performance. At that point (up to October 15 of the following year) he can “recharacterize” the IRA as a traditional IRA and, if he wishes, try the conversion again the following year, at presumably a lower tax cost.
The year 2008 aside, it’s unusual to experience a 25% decline in a well-diversified, balanced portfolio. However, any one asset class could have an off year or two, which leads into the next Roth conversion strategy. Consider breaking out your new Roth IRA into 3-5 separate accounts consisting of uncorrelated asset classes. You can then cherry pick the losing account to achieve a lower tax cost via recharacterization, while leaving the winners to keep growing and eventually pay out tax-free profits. For example, assume Jack placed one-third of his Roth assets in taxable bonds, one-third in international stocks, and one-third in U.S. growth stocks. In the 21 month period ending October 2011, his taxable bond Roth account returned 5%, international stocks declined 30%, and U.S. growth stock returned 10%. Jack could recharacterize the Roth IRA invested in international stocks which lost $100,000 in value, thereby reducing his Roth IRA conversion tax liability.
There are a significant number of tax and financial considerations that come into play when determining whether to convert your traditional IRA to a Roth IRA. Please consult with your tax and financial professional about this new 2010 planning opportunity.