To Convert, or Not To Convert: That is the Question – Spring 2010
To convert, or not to convert: that is the question:
Whether ‘tis nobler in the mind to suffer
The slings and arrows of tax increases,
Or to take action against a sea of future required minimum distributions, And by converting end them?
OK, now that Shakespeare is spinning in his grave, let’s tackle the tax dilemma du jour: Whether to convert a traditional IRA into a Roth IRA. First, some facts:
Traditional IRAs are generally funded with assets that have not yet been taxed. Every penny of principal and earnings is taxed upon withdrawal at the participant’s tax bracket at the time. Roth IRAs, on the other hand, are funded with contributions that have already been taxed. Earnings on Roth IRAs are not taxed if withdrawals are qualified; that is: the Roth IRA is at least five years old and the participant is older than age 59 ½.
When converting from a traditional to a Roth IRA, the entire amount converted is taxed as ordinary income in the year of conversion. In 2010, the former restriction upon conversion for high income earners has been eliminated: anyone can convert all or part of their IRAs to Roths this year. When filing your 2010 tax return, you will make a choice: 1) Pay all of the tax in tax year 2010, or 2) split the taxation between tax years 2011 and 2012.
We have a graduated income tax system; in other words, the higher the taxable income, the higher the percentage of it is taxed. The marginal brackets at almost all income levels will increase in 2011. In 2010 the brackets are 10%, 15%, 20%, 28%, 33%, and 35%. In 2011 the brackets will be: 15%, 25%, 28%, 31%, 36%, and 39.6%.
Traditional IRAs are subject to taxable Required Minimum Distributions (RMDs) beginning at age 70 ½. Roth IRAs are not subject to RMDs.
So now that we are armed with the facts, let’s delve a bit deeper. There are three factors that should be considered when making the conversion decision:
1) Do you expect your tax bracket to be higher or lower than your current bracket in the withdrawal years?
As noted, for a given income level, the brackets are increasing somewhat in 2011. The trend toward higher government spending is likely to result in the need for increased revenue in subsequent years. However, it is not clear that this will be accomplished through the income tax. Instead, it may take the form of a Value Added Tax (VAT), or some other device. However on balance, if I were a betting man (I’m not) I would guess that income tax rates will increase over the coming years.
Your personal situation will also have a major effect upon your future tax bracket. For example, if you are now in your peak earning years and expect to retire shortly, your income tax bracket is likely to fall. However, if you are already retired, or will have a high retirement income derived from taxable pensions and traditional IRA withdrawals, your bracket may never be lower than it is now.
An income tax bracket that will be higher in the withdrawal years tends to make a Roth IRA conversion beneficial; a bracket that will be lower makes it detrimental.
2) Can you pay the conversion tax from a source other than the IRA itself?
Let’s say that you are in a 25% tax bracket and are converting $100,000 from your traditional to your Roth IRA. The conversion tax is $25,000. It is best to pay that tax using money other than an additional IRA distribution. If the only source of money is an extra $25,000 IRA distribution, that withdrawal will also be taxable, will reduce your tax advantage and be detrimental. If the conversion happens before age 59 ½, it is subject to a $2,500 (10%) penalty as well.
Having funds in non IRA accounts with which to pay the tax tends to make conversions more beneficial. Paying the conversion tax with additional IRA distributions is detrimental.
3) Do you need your full Required Minimum Distributions to live on beginning at age 70 ½?
If you will not need the full amount of your RMDs right away at age 70 ½, a Roth IRA will allow you to keep those amounts in the Roth in a tax favored account for a longer period of time in which tax free growth can take place. The traditional IRA requires taxable RMD withdrawals to be taken whether or not you need the funds to live on, and therefore forces you to pay tax on funds you may not need until later.
If you will not need all of your RMD amounts at age 70 ½, a Roth conversion may be beneficial.
The ideal situation favoring a beneficial Roth IRA conversion is this: 1) You expect your income tax bracket to rise or stay flat over the coming retirement years. 2) You have accounts outside of the IRA with which to pay the conversion tax. 3) You will not need the full RMD amounts to live on right away at age 70 ½.
If you have all or any of these issues, you may want to stay put in your traditional IRA: 1) You expect your tax bracket to fall. 2) You have no account outside the IRA with which to pay the conversion tax 3) You will need the full RMD amounts to live on right away at age 70 ½.
Generally, high net worth investors are better served by Roth IRA Conversions than are those who have limited means. Those with limited means tend to be able to withdraw from their traditional IRAs after they retire in brackets that are lower than during their working years. They are also less likely to have non IRA accounts from which to pay the conversion tax.
Many high net worth investors are able to maintain their preretirement income level for life, and much of that retirement income tends to be taxable. Their social security retirement benefits are taxed at a higher rate. It is likely that their income tax brackets will not drop in retirement.
We often recommend partial Roth conversions rather than making one large lump sum conversion. A very large lump sum conversion will tend to put you into a higher tax bracket. This can be avoided if small partial conversions are made over a series of years instead.
We speak of balance when referring to asset types, but it also makes sense to achieve some degree of balance among funds of different tax status. By having some funds in a traditional IRA and some in a Roth IRA, taxable income can be controlled to advantage. For example, in a high tax year it would be wise to withdraw funds from the Roth IRA to avoid paying tax in a high bracket. Conversely, in a year with large deductions such as medical costs, funds may be able to be withdrawn from a traditional IRA in a 0% tax bracket.
If after converting to a Roth, you decide it was a mistake, you have until October 15th of the following year to put the funds back into the traditional IRA as though it never happened. If assets that have been converted fall in value, they can be put back into the traditional IRA, and after a wait of 30 days can be converted again at the lower value, resulting in a lower tax.
If you are wondering whether a Roth Conversion makes sense for you; don’t hesitate to ask us. Every client situation is unique and requires individual evaluation. We will take into account your entire unique situation before advising you.