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.