Wise Wealth Management

Dennis Covington | Principal

Insights on the keys to enjoying a "healthy wealth".

What's All the Fuss About Roth IRA Conversions?

December 2009

Roth IRAs have been around since 1998, yet most of our clients don’t have a Roth IRA. The reason is that the ability to contribute or convert traditional IRAs to Roth IRAs has been limited to taxpayers with relatively low Adjusted Gross Incomes (AGI).

Despite this limitation, you will be hearing more and more about the opportunity to convert traditional IRAs to Roth IRAs in 2010. The reason for this renewed interest is that the income phase-out to convert traditional IRAs to Roth IRAs, which used to be set at $100,000, will be eliminated in 2010. In addition, Congress has permitted the income recognition on these conversions in 2010 to be recognized in 2011 and 2012. Therefore, the financial press and Wall Street are cranking up their marketing machines to encourage investors to consider a Roth IRA conversion. But, just because you can convert to a Roth IRA does not mean you should.

As a refresher, the primary difference between Roth IRAs and traditional IRAs is that Roths are funded with after-tax contributions instead of pre-tax contributions. As a result, Roths have two big advantages over their traditional cousins:

1. Earnings on contributions grow tax-free in Roth IRAs vs. tax-deferred in traditional IRAs (tax-free treatment requires five-year holding period and attainment of age 59½).

2. Roth IRAs do not have the Required Minimum Distribution (RMD) at age 70½ provisions that traditional IRAs have. In other words, if you don’t need the money in your IRAs to live on and want to leave an income-tax-free Roth IRA to your heirs for gift and estate planning purposes, Roth IRAs make a great deal of sense.

So if Roth IRAs make so much sense, why would you not convert your traditional IRA to a Roth? That answer is that Roth IRA conversions require you to pay the tax now (or, with the new rules, in 2011 and 2012). And, since you don’t want to use money from the IRA to pay the tax (which would greatly diminish the size of your IRA and thus the amount of compounding your portfolio would be able to do), you would need to pay the tax out-of-pocket. For a large IRA, this can be a sizeable chunk of money. For example, converting a $500,000 traditional IRA to a Roth would result in a tax bill of around $205,000, depending on your state’s income tax rate.

Still, even though you have to pay current income tax on the amount you convert to a Roth IRA, it may make sense for some people. Here is a decision matrix for you:

Unlikely Candidate

Likely Candidate

Expects tax rates to go down

Expects tax rates to go up in the future

--- AND ----

--- AND ----

Does not have cash available to pay tax on the conversion

Has cash available to put toward tax due on conversion

--- AND ----

--- AND ----

Projected retirement income needs are equal to or greater than RMDs

Projected retirement income needs are less than projected RMDs

The conversion rules do allow for a partial conversion which may allow you to capture some of the benefits of conversion without wiping out your cash reserves. In addition, some taxpayers may find themselves in low tax brackets due to the economic slowdown and a partial conversion may make sense to the extent you can pay tax on the conversion amount at lower rates.

Keep in mind that even the opportunity to delay and spread the income recognition to 2011 and 2012 may not be a benefit because the tax act that reduced the top marginal rate at 35% is set to expire at the end of 2010, after which the highest marginal rates will go up in 2011 and 2012. Thus, if a conversion makes sense, you may be better off paying the entire tax in 2010.

It is important to recognize that the primary reason for this rule change was to accelerate the collection of income taxes that might have otherwise been locked up in traditional IRAs for decades to come. Therefore, I don’t believe that we will see an enormous amount of people take advantage of the 2010 Roth conversion opportunity.

The bottom line is that if you don’t need the assets in your retirement accounts in your lifetime you should take a look at a Roth conversion. Otherwise, take a look at the matrix above and if you’re a “Likely Candidate,” or somewhere close, feel free to call me if you want to take a closer look at your unique set of facts and circumstances.

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