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To Convert to a Roth IRA or Not?

That is a very important financial and estate planning question worthy of serious consideration by anyone who has a qualified retirement plan or IRA.

The Good News: As of January 1, 2010, the $100,000 or less adjusted gross income threshold for converting a traditional IRA to a Roth has been permanently repealed. So now regardless of earned income you can convert a traditional IRA (and generally employer-sponsored retirement plans) to a Roth IRA.

The Bad News: The conversion is a taxable event and the amount converted is subject to ordinary income tax.

Example: In January 2010, a taxpayer in the 35% bracket converts $100,000 from a traditional IRA to a Roth. The conversion generates a federal income-tax liability of $35,000.

Planning pointers: (1) The taxpayer has the option of paying the tax with his 2010 tax return or electing to pay the tax in two equal installments with his or her 2011 and 2012 tax returns. Note: It’s likely that income-tax rates will be higher in 2011 and after.

(2) What if the Roth investments decrease in value after the conversion? Let’s say the conversion to a Roth IRA takes place in early 2010 and has a value of $100,000. A market correction ensues and brings down the value of the Roth to $80,000. The conversion tax is still based on $100,000 and in the 35% bracket it amounts to $35,000.

What to Do? The owner is permitted to reconvert to a regular IRA and forget about the tax. But the reconversion has to be done no later than October 15 of the following year, 2011 in this case. The owner cannot convert to a Roth again until 2012.

(3) Consider opening more than one Roth IRA account to house different classes of assets. The Roths with investment classes that perform well can be retained. The Roths that don’t can be converted back to traditional IRAs.

Softening the Impact of the Tax Liability Through Charitable Giving

The tax impact can be ameliorated by making charitable gifts, both outright and deferred. Because of the significant tax liability, one option to consider is to accelerate and compress future charitable gifts that you would ordinarily make into the year of the conversion.

Example: You usually make annual charitable gifts of say $10,000 a year. You could transfer $50,000 (5 years’ worth) or $100,000 (10 years’ worth) into a donor-advised fund this year. You will be entitled to a charitable deduction of an equal amount, so if it is $100,000 this will result in an income-tax savings of $35,000 (35% of $100,000) to offset some or all of the tax liability resulting from the conversion.
 
You can also stagger the conversions over several years and pay the tax over several years.

Special Roth IRA Benefits to Note:

• No required withdrawals after age 70½. Unlike traditional IRAs, Roth IRAs are not required to distribute a minimum amount each year after the account owner turns 70½. This is a tremendous benefit for those who don’t need additional income for retirement.
• Contributions are allowed after age 70½. If you meet the income requirements, you
  can continue to make contributions to a Roth IRA after you turn 70½. This is not so with traditional IRAs.
• Roth IRA distributions are income-tax free to you and to your beneficiaries.

Who Should Consider Converting to a Roth IRA? A person who…

• Can afford to pay the conversion tax and do so from sources other than the IRA. Otherwise, the whole purpose of the conversion is defeated.
• Does not expect to be in a lower tax bracket in retirement.
• Will probably not need to touch the Roth for living expenses until much later, if ever.
• Is younger, although this could work well for an older person in good health.
• Wishes to provide for beneficiary(ies) who will stretch benefits over life expectancy(ies).