Throughout 2010, you will be awash in conflicting opinions about whether or not converting your traditional IRA to a Roth IRA is a good financial move.
By way of background, anyone at anytime can convert a traditional IRA to a Roth if they meet the qualifications. Up until 2010, there had been an adjusted gross income threshold above which you could not convert. That amount was $100,000. In 2010, there is no constraint due to income so now everyone has an opportunity to convert. The second critical qualification is to pay the income tax on the funds withdrawn from the traditional IRA in the year of conversion. With a 2010 conversion, the IRS will permit payment of the tax over 2 years.
The decision to covert is more complicated than just abiding by the two qualifying factors I just mentioned. A qualified tax expert should be consulted so you understand all of the tax ramifications about doing a conversion.
I want to shift gears and present a financial analysis of the conversion decision that examines more closely the consequences of paying the income tax upon conversion. In the parlance of finance, there is what is known as the opportunity cost - the measure of what is lost or what is not gained by using money that could otherwise be invested for a higher return, particularly if there is a long term time horizon in front of you.
I have published several articles on this topic. They are all posted within this blog. I invite you to read each article and hopefully you will have the information you need to determine the next step about executing a conversion in 2010.
In my opinion, your income tax status before and after the conversion has to remain essentially the same throughout your life, your beneficiary's life and the lives of any subsequent beneficiaries for a conversion to be income tax neutral. Otherwise there could be negative permanent tax differences that might disqualify the conversion because of the opportunity cost I previously mentioned.
Those of you have built up substantial traditional IRA balances will also have substantial deferred tax benefits within the account that stretch decades into the future. You need to be concerned about converting these deferred income taxes to an immediate income tax liability, which is why a more rigorous analysis has to be done before making a decision.
Sunday, January 17, 2010
Roth Conversion Check List
Crossing the Social Security taxable income threshold and its effect on the economics of a Roth IRA conversion
In my previous articles on this site I rendered an opinion that it is not a good financial decision to convert a traditional IRA with a substantial deferred tax liability to a Roth IRA because of the conversion tax. For most, the opportunity cost of paying that tax in a lump sum upon conversion would probably not be recovered during the owner’s life time.
However, my previous articles did not address assumptions about the impact that the required minimum distribution could have on the taxable portion of Social Security benefits. My implied assumption was that at least half of the benefit would be taxable, as it is for most, and an issue only arises if the traditional IRA RMD results in the benefit becoming 85% taxable.
The issue of how much Social Security is taxable has a lot to do with all of the other sources of your retirement income. Generally, if Social Security is your only source of income in retirement, then it is most likely to be tax free. However, by having a taxable required minimum distribution from a traditional IRA, you could surpass the threshold for taxation of benefits, incurring a higher marginal tax as a result. This would degrade the benefits of staying with the traditional IRA instead of converting to a Roth. Most of you will have other sources of income in retirement resulting in taxation of part of you Social Security benefits anyway that makes this issue moot.
For married people filing jointly that threshold is $32,000. If one-half of you Social Security income plus all other income that includes the IRA RMD, plus adding in any tax free income, exceeds $32,000, then one-half of your Social Security benefits will be taxable. Should all of you other sources of taxable and tax free income – pensions, dividends, annuity payments, regular wages and interest on municipal bonds, push your income above $44,000 (married filing jointly) then it might make 85% of your Social Security income taxable. If your retirement income projects income from sources other than Social Security or IRA distributions, then the tax consequences on Social Security are not likely to changed by a Roth conversion. Stay with the traditional IRA instead.
However, the marginal or additional tax incurred when Social Security becomes taxable as a result of the RMD from a traditional IRA, if that is the only other source of taxable income, makes the Roth conversion a better decision. This means you have to accurately project all other sources of income in retirement to make this decision. Obviously, if Social Security and your IRA are the only sources of income, it will be advantageous to convert to a Roth and keep the Social Security completely tax free.
The Roth IRA conversion is more complicated then it seems because you have to thoroughly estimate the sources of all future income and determine whether or not these will have any substantial impact on your normal or historical tax rate in retirement.
Roth IRA Conversion Checklist
Now that 2010 has arrived, all of you with a Traditional IRA have an option to convert it to a Roth IRA and forever have a completely tax free retirement account.
I have written several articles, all available on this site, on whether or not the conversion is a good financial decision, particularly if the traditional IRA had built-up substantial deferred income taxes that won’t be paid back until after your death. I would like to summarize these articles in a check list format so that the decision factors can be presented to you in one source document.
You can only base your decision on tax rates as of today. No one can project what future tax rates will be. Here are the factors to evaluate.
If any of these apply or you are unsure about, then consultation with an expert should be considered.
Tax bracket in year of conversion (2010 tax rate structure):
A conversion bumps me up to a higher tax bracket in 2010?
I will be in that tax bracket when I retire?
I will be in a lower tax bracket than 2010 when I retire I will be I a higher tax bracket that 2010 when I retire I Have considered the impact on state and local income taxes
(For example, will you be moving to or from a state with no income taxes)
Payment of conversion tax:
I have determined the opportunity cost from paying the tax (default rate of 7%) (In other words, I would be better off keeping the money invested instead of paying the conversion tax)
I will recover this cost during my life time
I have determined the required rate of return to break-even and believe I can earn that rate on my investments every year in the future
Disposition of your IRA:
I expect to spend down my IRA during my life time
My spouse as beneficiary when required to take minimum distributions will be in a tax bracket that is: Higher than ours is in 2010
Lower than ours is in 2010
My non-spouse as beneficiary when required to take minimum distributions will be in a tax bracket that is:
Higher than mine is in 2010
Lower than mine is in 2010
Taxation of Social Security benefits (today’s rules):
Traditional IRA required minimum distribution result in my or my spouse’s social security benefits:
Will be taxed for the first time
Will raise taxation of our benefits from 50% to 85%
Factors having no consequences on conversion decision:
My age
I will spend my entire IRA during my life time
Conversion in 2010 will not change my 2010 tax rate
I plan on staying in the same state when I retire
RMD will have no impact on taxation of my or my spouse’s Social Security benefits
My tax bracket when taking required minimum distributions will be the same as in 2010
My beneficiaries – both spousal and non spousal – will be in my 2010 tax bracket when they take required minimum distributions in the future
Finally:
I will never take any money out of my Roth IRA during my life time, then I should go for it!
In my previous articles on this site I rendered an opinion that it is not a good financial decision to convert a traditional IRA with a substantial deferred tax liability to a Roth IRA because of the conversion tax. For most, the opportunity cost of paying that tax in a lump sum upon conversion would probably not be recovered during the owner’s life time.
However, my previous articles did not address assumptions about the impact that the required minimum distribution could have on the taxable portion of Social Security benefits. My implied assumption was that at least half of the benefit would be taxable, as it is for most, and an issue only arises if the traditional IRA RMD results in the benefit becoming 85% taxable.
The issue of how much Social Security is taxable has a lot to do with all of the other sources of your retirement income. Generally, if Social Security is your only source of income in retirement, then it is most likely to be tax free. However, by having a taxable required minimum distribution from a traditional IRA, you could surpass the threshold for taxation of benefits, incurring a higher marginal tax as a result. This would degrade the benefits of staying with the traditional IRA instead of converting to a Roth. Most of you will have other sources of income in retirement resulting in taxation of part of you Social Security benefits anyway that makes this issue moot.
For married people filing jointly that threshold is $32,000. If one-half of you Social Security income plus all other income that includes the IRA RMD, plus adding in any tax free income, exceeds $32,000, then one-half of your Social Security benefits will be taxable. Should all of you other sources of taxable and tax free income – pensions, dividends, annuity payments, regular wages and interest on municipal bonds, push your income above $44,000 (married filing jointly) then it might make 85% of your Social Security income taxable. If your retirement income projects income from sources other than Social Security or IRA distributions, then the tax consequences on Social Security are not likely to changed by a Roth conversion. Stay with the traditional IRA instead.
However, the marginal or additional tax incurred when Social Security becomes taxable as a result of the RMD from a traditional IRA, if that is the only other source of taxable income, makes the Roth conversion a better decision. This means you have to accurately project all other sources of income in retirement to make this decision. Obviously, if Social Security and your IRA are the only sources of income, it will be advantageous to convert to a Roth and keep the Social Security completely tax free.
The Roth IRA conversion is more complicated then it seems because you have to thoroughly estimate the sources of all future income and determine whether or not these will have any substantial impact on your normal or historical tax rate in retirement.
Roth IRA Conversion Checklist
Now that 2010 has arrived, all of you with a Traditional IRA have an option to convert it to a Roth IRA and forever have a completely tax free retirement account.
I have written several articles, all available on this site, on whether or not the conversion is a good financial decision, particularly if the traditional IRA had built-up substantial deferred income taxes that won’t be paid back until after your death. I would like to summarize these articles in a check list format so that the decision factors can be presented to you in one source document.
You can only base your decision on tax rates as of today. No one can project what future tax rates will be. Here are the factors to evaluate.
If any of these apply or you are unsure about, then consultation with an expert should be considered.
Tax bracket in year of conversion (2010 tax rate structure):
A conversion bumps me up to a higher tax bracket in 2010?
I will be in that tax bracket when I retire?
I will be in a lower tax bracket than 2010 when I retire I will be I a higher tax bracket that 2010 when I retire I Have considered the impact on state and local income taxes
(For example, will you be moving to or from a state with no income taxes)
Payment of conversion tax:
I have determined the opportunity cost from paying the tax (default rate of 7%) (In other words, I would be better off keeping the money invested instead of paying the conversion tax)
I will recover this cost during my life time
I have determined the required rate of return to break-even and believe I can earn that rate on my investments every year in the future
Disposition of your IRA:
I expect to spend down my IRA during my life time
My spouse as beneficiary when required to take minimum distributions will be in a tax bracket that is: Higher than ours is in 2010
Lower than ours is in 2010
My non-spouse as beneficiary when required to take minimum distributions will be in a tax bracket that is:
Higher than mine is in 2010
Lower than mine is in 2010
Taxation of Social Security benefits (today’s rules):
Traditional IRA required minimum distribution result in my or my spouse’s social security benefits:
Will be taxed for the first time
Will raise taxation of our benefits from 50% to 85%
Factors having no consequences on conversion decision:
My age
I will spend my entire IRA during my life time
Conversion in 2010 will not change my 2010 tax rate
I plan on staying in the same state when I retire
RMD will have no impact on taxation of my or my spouse’s Social Security benefits
My tax bracket when taking required minimum distributions will be the same as in 2010
My beneficiaries – both spousal and non spousal – will be in my 2010 tax bracket when they take required minimum distributions in the future
Finally:
I will never take any money out of my Roth IRA during my life time, then I should go for it!
No Benefit From Roth IRA Conversion
No Benefit From Roth IRA Conversion
A follow up to my previous article: Roth Conversion in 2010, Don’t Do It.
I see your still getting conflicting opinions about converting a traditional IRA to a Roth in 2010 when there are no IRS income restrictions. And, it’s still not a good financial decision.
There’s actually a very easy way to decide. Ask yourself this question “would I do it if I am 701/2 years old? You probably would not. If that’s the answer, then why would you consider doing it at any other age?
A 701/2 year old has a traditional IRA worth $200,000 and is in the 28% tax bracket. This individual has a choice to make: pay the tax now on a conversion to a Roth or pay it over the next 50 years – which is how long you get to pay the deferred taxes on a traditional IRA.
By converting to a Roth IRA the individual would have to come up with $56,000 to pay the tax now. Instead, let’s put this same $56,000 into its own traditional IRA as cash – earning nothing. The individual has to take required minimum distributions as prescribed by law. The first withdrawal is 3.77% of the account balance. Amortize the $56,000 balance according to the official RMD schedule and the account would be depleted at age 120. Think about how much this account would accumulate if you could earn a return higher than 3.77%.
Let’s go younger. You’re 30 years old with a $30,000 traditional IRA. The conversion tax to a Roth is $8,400 at the 28% tax rate. If that amount stayed invested in the IRA earning 7%, it would grow tax deferred to $126,000 at age 70 ½. Put that amount in its own IRA and amortize it just like in the example above.
It seems to me that if I owed someone money, like the Government for taxes way into the future and there are no financing charges, why would I pay it off all at once now? I know there are many other Ezine articles that advocate converting to a Roth due to the tax free appeal, but most do not address the time value of money of the lump sum payment versus installment payments.
A follow up to my previous article: Roth Conversion in 2010, Don’t Do It.
I see your still getting conflicting opinions about converting a traditional IRA to a Roth in 2010 when there are no IRS income restrictions. And, it’s still not a good financial decision.
There’s actually a very easy way to decide. Ask yourself this question “would I do it if I am 701/2 years old? You probably would not. If that’s the answer, then why would you consider doing it at any other age?
A 701/2 year old has a traditional IRA worth $200,000 and is in the 28% tax bracket. This individual has a choice to make: pay the tax now on a conversion to a Roth or pay it over the next 50 years – which is how long you get to pay the deferred taxes on a traditional IRA.
By converting to a Roth IRA the individual would have to come up with $56,000 to pay the tax now. Instead, let’s put this same $56,000 into its own traditional IRA as cash – earning nothing. The individual has to take required minimum distributions as prescribed by law. The first withdrawal is 3.77% of the account balance. Amortize the $56,000 balance according to the official RMD schedule and the account would be depleted at age 120. Think about how much this account would accumulate if you could earn a return higher than 3.77%.
Let’s go younger. You’re 30 years old with a $30,000 traditional IRA. The conversion tax to a Roth is $8,400 at the 28% tax rate. If that amount stayed invested in the IRA earning 7%, it would grow tax deferred to $126,000 at age 70 ½. Put that amount in its own IRA and amortize it just like in the example above.
It seems to me that if I owed someone money, like the Government for taxes way into the future and there are no financing charges, why would I pay it off all at once now? I know there are many other Ezine articles that advocate converting to a Roth due to the tax free appeal, but most do not address the time value of money of the lump sum payment versus installment payments.
Roth IRA Conversion – Don’t Do It
Roth IRA Conversion – Don’t Do It
By Thomas Warren, CFP®
August, 2009
Are you considering converting to Roth IRA in 2010 when there are no IRS restrictions? If you decide to do so you are required to pay income taxes on the amount converted. This payment now of the taxes you would ordinarily pay many, many years into the future has a significant opportunity cost that you may not be aware of that makes converting a poor financial decision.
In 2010, anyone with a traditional IRA can convert that account to a Roth IRA without having to comply with existing IRS limits for adjusted gross income.
There is a strong temptation to want to do this. A Roth IRA allows you to accumulate assets for retirement with no future income tax consequence; there is no required minimum distribution at any age; and the ability to "stretch" the Roth IRA across multiple generations still exists.
Great! Can you pay the income tax on conversion? Traditional IRA distribution rules still apply when you convert, except there is no 10% penalty for the distribution if you are under age 59 ½. You can spread the tax payment across 2 tax years.
Say you don't mind paying the conversion tax. Then is it a good financial decision?
The answer is a flat out no - not at any age and not at any tax rate up to 52%.
A large segment of the population has saved for retirement through tax qualified plans such as a 401k; they might also have been participating in a profit sharing plan. They have built up substantial amounts of deferred tax liability prior to and after the Roth was introduced in 1998. When these funds are rolled over to a traditional IRA all of the deferred tax liabilities are transferred as well, to be paid out in installments many years from now.
To illustrate: You're 55 years old and have an IRA worth $500,000. The conversion puts you in the highest marginal federal tax bracket - 35%, plus (if you live in NY) 7% for state taxes. Total conversion tax - $210,000.
You're still more than 15 years away from taking a required minimum distribution (RMD) if you stayed with the traditional IRA. The RMD would start at around 3.8% at age 70½ rising gradually to be more than 9% when you're in your 90's. That's a long way from today when you are 55.
Using the time value of money, let's employ a 7% opportunity rate to compute the present value today of the future tax liability on RMDs from the time you're 70 ½ to age 95. Today's account balance of $500k has been advanced forward to age 70 ½ by 7% as well, to a value of nearly $1.4 million. That's a lot of tax deferred growth, would you say?
The stream of tax payments beginning at age 70½ totals $941,037 through age 95 using your normal federal rate of 26% and 7% for the state, or 33% combined. These tax payments have a present value cost today (age 55) of $132,414 at the 7% discount rate.
The conversion tax is $210,000. By itself, the higher lump sum payment compared to the present value of the future taxes, a difference of $78,000 suggests not converting. You may have some difficulty with my analysis for not using the same marginal tax rate during the RMD phase as I did with the conversion tax. O.K., let's see if that makes a difference. No. While the future tax payments will be in excess of $1.2 million, the present value today is just $168,881, still more than $40,000 below the conversion tax.
However, this is not the true economic cost. By removing $210,000 from your investments now might deprive you of the potential for nearly $3.1 million in investment gains over the next 40 years. Whereas the benefit from the avoided tax payments that can be invested in the future are approximately $2.0 million at the 33% rate and $2.45 million at the 42% rate. This results in a net conversion cost on nearly $1.2 million and $.7 million, respectively.
Just for the heck of it. What is the highest future marginal tax rate before a conversion has an economic benefit? 52%. This may happen with the pending "America's Affordable Health Choices Act of 2009". But, how many of you are likely to be in the top bracket then?
Here we have another example of compounding - "the gift of time/the curse of time"; the payment of the lump sum conversion tax removes the potential to earn $3.1 million over the next 40 years, the curse of time; the taxes saved after age 70 ½ have a future value if invested of $1.9 million, but the investment term is only 25 years, the gift of time; however, the first 15 years does not have any investment or tax benefits, just an opportunity cost, that clearly makes the conversion decision a slam dunk no!
By Thomas Warren, CFP®
August, 2009
Are you considering converting to Roth IRA in 2010 when there are no IRS restrictions? If you decide to do so you are required to pay income taxes on the amount converted. This payment now of the taxes you would ordinarily pay many, many years into the future has a significant opportunity cost that you may not be aware of that makes converting a poor financial decision.
In 2010, anyone with a traditional IRA can convert that account to a Roth IRA without having to comply with existing IRS limits for adjusted gross income.
There is a strong temptation to want to do this. A Roth IRA allows you to accumulate assets for retirement with no future income tax consequence; there is no required minimum distribution at any age; and the ability to "stretch" the Roth IRA across multiple generations still exists.
Great! Can you pay the income tax on conversion? Traditional IRA distribution rules still apply when you convert, except there is no 10% penalty for the distribution if you are under age 59 ½. You can spread the tax payment across 2 tax years.
Say you don't mind paying the conversion tax. Then is it a good financial decision?
The answer is a flat out no - not at any age and not at any tax rate up to 52%.
A large segment of the population has saved for retirement through tax qualified plans such as a 401k; they might also have been participating in a profit sharing plan. They have built up substantial amounts of deferred tax liability prior to and after the Roth was introduced in 1998. When these funds are rolled over to a traditional IRA all of the deferred tax liabilities are transferred as well, to be paid out in installments many years from now.
To illustrate: You're 55 years old and have an IRA worth $500,000. The conversion puts you in the highest marginal federal tax bracket - 35%, plus (if you live in NY) 7% for state taxes. Total conversion tax - $210,000.
You're still more than 15 years away from taking a required minimum distribution (RMD) if you stayed with the traditional IRA. The RMD would start at around 3.8% at age 70½ rising gradually to be more than 9% when you're in your 90's. That's a long way from today when you are 55.
Using the time value of money, let's employ a 7% opportunity rate to compute the present value today of the future tax liability on RMDs from the time you're 70 ½ to age 95. Today's account balance of $500k has been advanced forward to age 70 ½ by 7% as well, to a value of nearly $1.4 million. That's a lot of tax deferred growth, would you say?
The stream of tax payments beginning at age 70½ totals $941,037 through age 95 using your normal federal rate of 26% and 7% for the state, or 33% combined. These tax payments have a present value cost today (age 55) of $132,414 at the 7% discount rate.
The conversion tax is $210,000. By itself, the higher lump sum payment compared to the present value of the future taxes, a difference of $78,000 suggests not converting. You may have some difficulty with my analysis for not using the same marginal tax rate during the RMD phase as I did with the conversion tax. O.K., let's see if that makes a difference. No. While the future tax payments will be in excess of $1.2 million, the present value today is just $168,881, still more than $40,000 below the conversion tax.
However, this is not the true economic cost. By removing $210,000 from your investments now might deprive you of the potential for nearly $3.1 million in investment gains over the next 40 years. Whereas the benefit from the avoided tax payments that can be invested in the future are approximately $2.0 million at the 33% rate and $2.45 million at the 42% rate. This results in a net conversion cost on nearly $1.2 million and $.7 million, respectively.
Just for the heck of it. What is the highest future marginal tax rate before a conversion has an economic benefit? 52%. This may happen with the pending "America's Affordable Health Choices Act of 2009". But, how many of you are likely to be in the top bracket then?
Here we have another example of compounding - "the gift of time/the curse of time"; the payment of the lump sum conversion tax removes the potential to earn $3.1 million over the next 40 years, the curse of time; the taxes saved after age 70 ½ have a future value if invested of $1.9 million, but the investment term is only 25 years, the gift of time; however, the first 15 years does not have any investment or tax benefits, just an opportunity cost, that clearly makes the conversion decision a slam dunk no!
Roth IRA Conversion in 2010: How to Make this Decision
Roth IRA Conversion in 2010: How to Make this Decision
By Thomas Warren, CFP®
December 10, 2009
No doubt soon you will be flooded with articles and “advisor speak” in the media about the benefits of converting all or part of you traditional IRA to a Roth IRA in 2010 when the income restrictions are removed. My guess is most of the opinions you hear will be in the favor of Roth.
Let me break it down to the key decision points:
Better dead than alive?
This is a multi-generational planning decision largely due to the fact that the required minimum distribution (RMD) factors for a traditional IRA extend well past the age of 100. What does this mean? The traditional IRA cannot be spent down during the owner’s life time if all they do is adhere to the RMD rates. Even if the account earns no investment returns, the account value falls to zero at around age 120. This is why I recommend that if you have a substantial tax deferral balance built up in your traditional IRA do not convert it to an immediate tax liability by going Roth. As I stated in my previous article, “Roth IRA Conversion – Don’t Do It”, the opportunity cost, or the potential investment returns foregone from paying the conversion tax, are not likely to be offset during the owner’s life time by the taxes avoided during the income phase of the IRA. They will be fully realized only when the IRA is terminated, usually well past the death of the original owner. Therefore, not only do you need to project what your future income tax rates could be, but those for the beneficiaries as well to determine if the conversion is a good financial decision.
Speculation about future higher income tax rates:
No one knows what income taxes will be beyond what they are today. A strong case can be made for assuming income tax rates for the highest income tiers will rise, while not so for the middle and lower income tiers. Then you have to consider how close you are to needing funds from the IRA. You may be able to project you tax rate with a high degree of confidence for the very near term. But, the intermediate and long term would be a wild guess. Those who are nearing retirement and expect to stay in the highest income tax bracket may want to analyze if they will recover the conversion cost during their life time before making this decision.
When it makes no difference:
The decision point is will the account be depleted during the owner’s life or the lives of the beneficiaries? There is no permanent difference when the combined income tax rates (federal, state and local) incurred at the time of conversion remains the same throughout the term of the IRA and the opportunity cost of the conversion tax can be disregarded only if the IRA is spent down during your life time. If the IRA is ever inherited complete equalization or tax neutralization if you prefer, is achieved only when the account, whichever one you choose, is fully depleted. If it occurs during the beneficiary’s lives, they also must have the same exact combined tax rate that was incurred at the time of the conversion and you still have to factor in the opportunity cost of the conversion tax during your life.
Permanent timing differences due to variable tax rates:
If the conversion puts you at a marginal tax rate that is higher than normal for you, and your taxable retirement income requirements based on today’s tax rates reverts back to your normal rate, and your beneficiaries are projected to have an income tax rate that is equal to or less than your normal rate, then a conversion will result in a permanent negative or unfavorable tax timing difference until the IRA is terminated. In other words, the timing difference will not reverse with time and staying with the traditional IRA would be preferred in this circumstance because the opportunity cost resulting from the lump sum tax payment cannot be fully recovered during the owner’s life time without taking on considerable investment risk.
If your future taxable retirement income is expected to be considerably more than the income you make today, based on today’s income tax rates you might be encouraged to complete a full conversion in 2010. But, there is still the opportunity cost of the conversion tax in your life time and the tax timing benefit may not be fully realized until it flows through to your beneficiary, and only if they are in the same or higher tax bracket.
Let me repeat the point I made in the beginning of the article. The timing differences whether neutral or permanent are only realized at the end of the IRA, after it has been fully spent – either by you or your beneficiaries.
Conclusion
As simple as the idea of “tax free” seems to you, it is extremely more complicated if you have already accumulated deferred tax liabilities. If you are contemplating the conversion, make sure you consult with a qualified advisor who can thoroughly evaluate the financial and investment consequences during your life and the life of your beneficiaries.
By Thomas Warren, CFP®
December 10, 2009
No doubt soon you will be flooded with articles and “advisor speak” in the media about the benefits of converting all or part of you traditional IRA to a Roth IRA in 2010 when the income restrictions are removed. My guess is most of the opinions you hear will be in the favor of Roth.
Let me break it down to the key decision points:
Better dead than alive?
This is a multi-generational planning decision largely due to the fact that the required minimum distribution (RMD) factors for a traditional IRA extend well past the age of 100. What does this mean? The traditional IRA cannot be spent down during the owner’s life time if all they do is adhere to the RMD rates. Even if the account earns no investment returns, the account value falls to zero at around age 120. This is why I recommend that if you have a substantial tax deferral balance built up in your traditional IRA do not convert it to an immediate tax liability by going Roth. As I stated in my previous article, “Roth IRA Conversion – Don’t Do It”, the opportunity cost, or the potential investment returns foregone from paying the conversion tax, are not likely to be offset during the owner’s life time by the taxes avoided during the income phase of the IRA. They will be fully realized only when the IRA is terminated, usually well past the death of the original owner. Therefore, not only do you need to project what your future income tax rates could be, but those for the beneficiaries as well to determine if the conversion is a good financial decision.
Speculation about future higher income tax rates:
No one knows what income taxes will be beyond what they are today. A strong case can be made for assuming income tax rates for the highest income tiers will rise, while not so for the middle and lower income tiers. Then you have to consider how close you are to needing funds from the IRA. You may be able to project you tax rate with a high degree of confidence for the very near term. But, the intermediate and long term would be a wild guess. Those who are nearing retirement and expect to stay in the highest income tax bracket may want to analyze if they will recover the conversion cost during their life time before making this decision.
When it makes no difference:
The decision point is will the account be depleted during the owner’s life or the lives of the beneficiaries? There is no permanent difference when the combined income tax rates (federal, state and local) incurred at the time of conversion remains the same throughout the term of the IRA and the opportunity cost of the conversion tax can be disregarded only if the IRA is spent down during your life time. If the IRA is ever inherited complete equalization or tax neutralization if you prefer, is achieved only when the account, whichever one you choose, is fully depleted. If it occurs during the beneficiary’s lives, they also must have the same exact combined tax rate that was incurred at the time of the conversion and you still have to factor in the opportunity cost of the conversion tax during your life.
Permanent timing differences due to variable tax rates:
If the conversion puts you at a marginal tax rate that is higher than normal for you, and your taxable retirement income requirements based on today’s tax rates reverts back to your normal rate, and your beneficiaries are projected to have an income tax rate that is equal to or less than your normal rate, then a conversion will result in a permanent negative or unfavorable tax timing difference until the IRA is terminated. In other words, the timing difference will not reverse with time and staying with the traditional IRA would be preferred in this circumstance because the opportunity cost resulting from the lump sum tax payment cannot be fully recovered during the owner’s life time without taking on considerable investment risk.
If your future taxable retirement income is expected to be considerably more than the income you make today, based on today’s income tax rates you might be encouraged to complete a full conversion in 2010. But, there is still the opportunity cost of the conversion tax in your life time and the tax timing benefit may not be fully realized until it flows through to your beneficiary, and only if they are in the same or higher tax bracket.
Let me repeat the point I made in the beginning of the article. The timing differences whether neutral or permanent are only realized at the end of the IRA, after it has been fully spent – either by you or your beneficiaries.
Conclusion
As simple as the idea of “tax free” seems to you, it is extremely more complicated if you have already accumulated deferred tax liabilities. If you are contemplating the conversion, make sure you consult with a qualified advisor who can thoroughly evaluate the financial and investment consequences during your life and the life of your beneficiaries.
Friday, November 13, 2009
Friday, November 6, 2009
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