By Paul V. Hamilton, Ph.D.
Paul Hamilton is an assistant professor of economics at Marshall University in Huntington, West Virginia. Contact him at HamiltonP@Marshall.edu.
- The year 2010 will allow higher income households the opportunity to convert traditional IRA assets to a Roth IRA. Three factors suggest this will provide a net benefit to converters: 1) the AMT allows conversions below regular marginal tax rates, 2) the taxable conversion income can be delayed into 2012 and 2013, and 3) impending tax hikes suggest 2010 is likely the best conversion opportunity high-income households will face well into the future.
- This article focuses on Roth conversion strategies for individuals with income above the AMT phase-out range making the effective marginal tax rate 28 percent. This is likely lower than the marginal tax in past years when contributions were made. Hence, a 2010 conversion allows individuals to lock in tax savings.
The year 2010 will provide higher-income households the opportunity to convert tax-deferred balances in traditional IRAs (TIRA) into post-tax Roth IRAs. The abolishment of the income cap will enable relatively high income earners the same conversion opportunity afforded others in past years. The question is, does this conversion opportunity present a net benefit to higher-income households? It is somewhat counterintuitive that those currently in the higher income brackets would benefit by paying taxes now, given that any conversion amounts will be subject to their top marginal rate. This article describes how high-income households can use the Alternative Minimum Tax (AMT) structure to convert at a relatively low rate of 28 percent. This is likely lower than their marginal rate in past years when TIRA contributions were made. Furthermore, it is quite possibly the lowest tax rate that would apply in the future to TIRA withdrawals or Roth conversions in what portends to be a higher tax environment in future years.
Fundamental Considerations In Roth Conversions
The Roth conversion decision has received considerable attention in the financial literature. Unfortunately, many studies have arrived at opposite conclusions on the merits of Roth accounts. These differences are driven by the assumptions underlying the models. The equivalency model described below is informative in that it shows, under reasonable assumptions, that a Roth conversion (or contribution) is equivalent to remaining with the TIRA (or contributing to a TIRA).
Equivalency Scenario: Bob has a $100,000 balance in a TIRA. Suppose his effective marginal tax rate on this amount is 25 percent currently and at the time of withdrawals. Furthermore, suppose that over his investment horizon all assets values double. If he keeps his assets in the TIRA then it will be valued (pre-tax) at $200,000 in the future. After taxes this will be reduced to $150,000. In contrast, if Bob converts the $100,000 TIRA to a Roth paying $25,000 in taxes and having an initial balance of $75,000, this will double to $150,000 (tax-free)-the same amount as the TIRA.
The preceding scenario highlights the important assumptions in comparing TIRA versus Roth. The primary variables are the relative levels of the current and future effective tax rates. Studies that have been supportive of TIRA (Blanchett, 2006) emphasize that effective tax rates in retirement are possibly lower than current rates due to lower spending levels and in the absence of Social Security benefits or other taxable income the use of lower brackets for part of the withdraw tax burden. Studies generally supportive of Roth conversions (Langdon, et al., 2006) emphasize the likelihood of future tax rate increases as well as the opportunity cost associated with paying conversion taxes with taxable account assets.
Roth assets generally are preferable over TIRA in other respects. Roth IRAs are not subject to RMD, conversion amounts are generally accessible without penalties after five years, and the post-tax Roth values lower the amounts potentially subject to estate taxes. See Kaye (2008) for detailed comparisons of Roth and TIRA.
The Alternative Minimum Tax and Roth Conversions
The AMT is an add-on tax for households who have a relatively high amount of disallowed exemptions relative to their adjusted gross income. The taxable income base for the AMT excludes numerous items most prominently being the personal exemptions, state and local taxes, and home equity loan interest expense if not used to enhance the home. The AMT is intended to keep wealthy households from circumventing their tax liability by taking excess exemptions and deductions. In recent years, due to long periods without inflation indexing of the thresholds, the AMT has become a factor in the tax picture for many not-so-wealthy households that did not have extraordinary deductions. However, the AMT comes into play much more frequently for households in the upper two tax brackets (e.g. households with incomes roughly in the $200,000-plus range).
The AMT tax structure is unlike the regular progressive tax brackets that range from 10 to 35 percent as the AMT has only two flat rates: 26 percent and 28 percent with a fixed exemption that is phased out for higher incomes. Table 1 illustrates in a simplified tax summary for a single person in 2010 with a range of gross income scenarios. Common to each scenario are $60,000 of "mutual reductions" that reduce both the regular and AMT taxable income (e.g. mortgage interest expense). Each scenario also assumes $30,000 of "regular-only reductions," which are disallowed under the AMT (e.g. state taxes).
Table 1: Interaction of Regular and AMT Tax for Different Levels of Gross Income
|- Mutual reductions||60,000||60,000||60,000||60,000||60,000|
|- Regular only reductions||30,000||30,000||30,000||30,000||30,000|
|= Regular Taxable Income||10,000||90,000||180,000||280,000||390,000|
|Regular Federal Income Tax||1,081||18,909||44,517||77,517||114,144|
|AGI - mutual reductions||40,000||120,000||210,000||310,000||420,000|
|- AMT exemption||48,101||48,101||48,101||48,101||48,101|
|+ AMT phase out||0||1,875||24,375||48,101||48,101|
|= AMT Taxable Income||0||73,774||186,274||310,000||420,000|
|AMT Federal Income Tax||0||19,181||48,657||83,300||114,100|
|Federal Income Tax||1,081||19,181||48,657||83,300||114,144|
|AMT marginal tax rate||26.00%||32.50%||35.00%||28.00%||28.00%|
|Regular marginal tax rate||15.00%||28.00%||33.00%||33.00%||35.00%|
In scenario 1 the individual has $100,000 of gross income of which only $10,000 is taxable under the regular federal tax. The AMT does not apply, as the AGI less the mutual reductions is less then the AMT exemption.
Scenarios 2 through 4 illustrate the AMT tax. In scenario 2, the gross income is just high enough to trip the AMT. Since AMT taxable income is less than $175,000, the stated AMT flat rate is 26 percent; however, the AMT exemption is being phased out at 25 cents on the dollar for each dollar that AGI less mutual reductions exceeds $112,500. Hence the effective marginal tax rate at this income level is 32.5 percent. Scenario 3 is similar, but gross income is high enough to push the AMT tax to 28 percent plus an additional 7 percent due to still falling in the AMT exemption phase-out range. Scenarios 4 and 5 are beyond the AMT phase-out range and hence only the 28 percent AMT flat rate applies. Scenario 5 illustrates that at a high enough income level the regular tax rate once again applies as the higher regular rate overcomes the disallowed reductions.
The income range from $370,000 to $480,000 is important in that this individual could experience the lower 28 percent marginal rate on additional income. A Roth conversion would qualify as additional income that is subject to this lower marginal rate. It is important to note that this particular situation is specific to the parameters described. If an individual has more disallowed reductions and/or less mutual reductions, the lower AMT rate will apply to a lower range of incomes.
Roth Conversion Versus Maintaining Traditional IRA
The primary questions are if to convert, how much to convert and when to pay the taxes-all in 2010, or split between 2011 and 2012? If income is relatively stable, so as not to place the Roth conversion income into a higher bracket and tax policy is unchanged, then the natural choice is to delay the payments. On the other hand, if in 2011 the current administration follows through on its plans to raise taxes on higher incomes, this could offset the benefits of delaying the taxable income.
Table 2: High-Income Individual Converting $100,000 in 2010
|+ Roth conversion (taxed)||0||100,000||0||0|
|= AGI + Roth conversion||359,223||470,000||381,100||392,533|
|- Mutual reductions||71,845||60,000||76,220||78,507|
|- Regular only reductions||35,922||30,000||38,110||39,253|
|= Regular Taxable Income||251,456||380,000||266,770||274,773|
|Regular Federal Income Tax||68,123||110,644||72,704||74,885|
|AGI - mutual reductions||287,379||410,000||304,880||314,026|
|- AMT exemption||46,700||48,101||49,544||51,030|
|+ AMT phase out||43,720||48,101||48,095||50,382|
|= AMT Taxable Income||284,398||410,000||303,431||313,378|
|AMT Federal Income Tax||76,132||111,300||81,461||84,246|
|Federal Income Tax||76,132||111,300||81,461||84,246|
|AMT marginal tax rate||35.00%||28.00%||35.00%||35.00%|
|Regular marginal tax rate||33.00%||35.00%||33.00%||33.00%|
Table 2 illustrates how an individual with gross income of $370,000 could benefit from converting $100,000 to a Roth IRA and paying taxes in 2010. Note that without the Roth conversion income, the individual has not exhausted the AMT exemption phase-out range (see 2009 column) and would be paying a 35 percent effective marginal AMT rate. The initial part of the Roth conversion is subject to this higher rate but then drops to 28 percent beyond the phase-out range. The present value of the $100,000 conversion is $10,694 or a 10.69 percent tax savings. A technical appendix provides the model details and an example of the calculations. A simple rule-of-thumb provides a good estimate of the net benefit to conversion-taking the 7 percent difference between the regular (35 percent) and AMT (28 percent) tax rate and multiplying by the conversion amount of $100,000 provides a $7,000 estimated benefit of converting to a Roth compared to withdrawing later from the TIRA.
Table 3: High-Income Couple Converting $300,000 and Paying Taxes in 2011/12
|+ Roth conversion (taxed)||0||0||150,000||150,000|
|= AGI + Roth conversion||485,437||500,000||665,000||680,450|
|- Mutual reductions||97,087||100,000||103,000||106,090|
|- Regular only reductions||48,544||50,000||51,500||53,045|
|= Regular Taxable Income||339,806||350,000||510,500||521,315|
|Regular Federal Income Tax||89,957||93,281||148,092||150,960|
|AGI - mutual reductions||388,350||400,000||562,000||574,360|
|- AMT exemption||70,950||73,079||75,271||77,529|
|+ AMT phase out||68,962||71,875||75,271||77,529|
|= AMT Taxable Income||386,362||398,797||562,000||574,360|
|AMT Federal Income Tax||104,681||108,163||153,860||157,321|
|Federal Income Tax||104,681||108,163||153,860||157,321|
|AMT marginal tax rate||35.00%||35.00%||28.00%||28.00%|
|Regular marginal tax rate||33.00%||33.00%||35.00%||35.00%|
Table 3 illustrates a high-income couple that will convert $300,000 to Roths in 2010, but split the taxable income over 2011 and 2012. Prior to the conversion income, the couple was at the edge of the AMT exemption phase-out range. The Roth conversion is taxed at 28 percent (the 35 percent regular rate is not applicable as the regular tax liability is less than the AMT tax liability). This rate of 28 percent is likely the best rate a very high income couple will face in withdrawing or converting TIRA. A financial adviser can compare this rate to the highest tax brackets in prior years when TIRA contributions were sheltered at rates up to 39.6 percent (1993-2000) or 50 percent (1982-86). The $300,000 conversion results in a tax-savings of $38,363 or 12.79 percent of the conversion amount. The equations given in the appendix can be used to derive this exact number. Alternatively, a modified rule-of-thumb is that the Roth conversion advantage is the sum of the 7 percent tax differential (28 percent versus 35 percent) plus the time value of money of 3 percent inflation due to the delay in recognizing the taxable income over the next two years.
Future Tax Structure
The 2010 Roth conversion opportunity coincides with potentially dramatic shifts in the federal tax code. The 2001 EGTRRA tax provisions sunset in 2011 setting the stage for major revisions including the default option of returning to the 2001 tax brackets. The potential policies are unlimited but many consider tax hikes a foregone conclusion given the administration's remarks to raise taxes on households earning more than $250,000, the $1.4 trillion deficit, and the rising cost of government programs.
There are an infinite number of ways that tax policy could shift over the next few years. One plausible structure is to keep intact the lower four brackets (10 percent, 15 percent, 25 percent, and 28 percent) but the upper brackets are raised to their 2001 rates. This would essentially coincide with President Obama's pledge not to raise taxes on the middle-class. The top marginal rate would rise from 35 percent to 39.6 percent. The AMT exemption level and brackets are assumed to be indexed to inflation, although the AMT structure could also be modified or even eliminated in future years.
If tax policy shifts to higher rates than this, it has ramifications for the 2010 conversion decision. First, higher rates in the upper brackets diminish the value of TIRA if the higher rates are expected to apply to future withdrawals. If the 2010 conversion was proceeded with and taxable income was to be reflected in 2011 and 2012, then these higher rates diminish the value of delaying the taxable income. The tax hike will impact the TIRA withdrawals more than the Roth conversion taxes in 2011/12. The individual described in Table 2 is subject to the AMT liability in 2011 and 2012 and hence the higher regular rates have no impact on the tax liability. The couple described in Table 3 will have net tax savings of $33,829 (11.28 percent of $300,000 conversion). In some scenarios it may be advantageous for the individual or couple who planned to delay the taxable income into 2011/12 to file a revised tax form possibly with late fees opting to pay the conversion taxes in 2010 at the lower rate. This depends on overall taxable income in each year and the associated tax schedules. For the couple described in Table 2, the tax hike reduced the net tax savings but is still the better option relative to recognizing all the conversion income in 2010 when net tax savings would have been only $27,586 (9.20 percent of the $300,000 conversion).
For households with incomes high enough to be beyond the AMT exemption phase-out, there is potentially an opportunity to convert TIRA assets into Roth IRAs. This strategy locks in the tax savings from earlier-year TIRA contributions when tax rates may have been as high as 50 percent. Although the future may produce opportunities to convert or withdraw TIRA assets at rates even lower than 28 percent, there is no guarantee as future rates may once again trend higher. Financial planners can present the case for Roth conversions with a defined tax saving rather than predicating the benefits on unknown and highly uncertain future tax rates. The ability to delay taxable income into 2011/12 strengthens the case for Roth conversions in 2010. Hence, the AMT structure provides an exception to the equivalency model for certain high-income households subject to the AMT rate of 28 percent with no expectation of withdrawals (or bequests) at lower regular income brackets.
Blanchett, David M. 2006. "Roth 401(k)s Are Wrong for Most 401(k) Participants: A Quantitative Analysis." Journal of Pension Benefits. 13, 2: 20-28.
Horan, Stephen M. 2006a. "Withdrawal Location with Progressive Tax Rates." Financial Analysts Journal. 62, 6: 77-87.
Horan, Stephen M. 2006b. "Optimal Withdrawal Strategies for Retirees with Multiple Savings Accounts." Journal of Financial Planning. 19,11 (Nov.): 62-75.
Langdon, Thomas P., E. Vance Grange, and Michael A. Dalton. 2006. "When Roth 401(k) and 403(b) Plans Outshine Traditional Plans." Journal of Financial Planning. 19, 7 (July): 60-67.
Thomas, Kaye A. 2008. Go Roth!: Your Guide to the Roth IRA, Roth 401k and Roth 403b Lisle, IL: Fairmark Press.
EDITOR'S NOTE: The original version of this article contained an incorrect tax rate. The article and spreadsheet have been revised to correct this error.