by David J. Gordon, CFP®, CIMA®
Executive Summary
- This article presents an overview of the features of the Roth IRA, including exploring guidelines for determining whether conversion from traditional IRAs to Roth IRAs makes the most sense.
- One guideline suggests that the longer the interval before eventual distribution, the greater the expected benefit of conversion from traditional to Roth IRAs.
- Another guideline suggests that increased return assumptions tend to favor conversion to Roth IRAs.
- Finally, when distribution tax rates are higher than conversion tax rates, there is an advantage to converting to a Roth IRA even if the conversion tax is taken from the IRA.
- Roth IRA conversions can also serve strategic purposes, especially in the areas of estate planning, asset protection, income tax considerations, gift tax advantages, estate tax mitigation, enhanced portfolio growth potential, and interaction with Social Security in other programs.
- The article then looks to the conversion opportunity specific to 2010, and explores recharacterization and re- conversion, as well as partial recharacterizations. In the case of full re-conversions of the Roth IRA balance in an account, no gain/loss calculation is needed; however, partial re-conversions must take into account the net income attributable, the gain or loss experienced while it was in the Roth IRA.
- Because Roth IRA owners and surviving spouses are not required to take required minimum distributions, Roth conversion can present a unique estate planning opportunity.
- 401(k) plans, annuities, and 403(b) annuities can all also be converted to Roth IRAs, and the guidelines for each, as well as tips for implementation, are explored.
David J. Gordon, CFP®, CIMA®, is managing director– investment officer in the Deerfield offices of Wells Fargo Advisors LLC, and is one of their top 100 financial advisers based on production at the time of this printing. A former practicing attorney since 1979, he is president emeritus of the Greater North Shore Estate Planning Council and ethics chairperson of the Investment Consultants Management Association. Gordon lectures at The Wharton School© and has written textbook chapters on fixed income and ethics.
Roth IRA conversions can offer many benefits, most notably, the suspension of required minimum distributions, future tax-free distributions for those meeting age and holding period requirements, and as a hedge against potential future tax hikes. Other less obvious benefits may include offsets to the conversion tax using carry forwards from items including charitable deductions, net operating loss (NOL), and investment tax credits. There is also potential for greater long-term growth when taxable assets are used to pay conversion taxes and there may be an estate tax savings from income tax payments made prior to the estate tax calculation, because no income tax deduction is allowed for state estate taxes levied on IRAs. The purpose of this article is to guide the decision-making advisory process by addressing the uncertainties, identifying economic opportunities, and providing a framework within which to make informed, objective choices.
In 2010, the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) eliminated the $100,000 modified adjusted gross income (MAGI) and tax filing status limitations for conversions to Roth IRAs from traditional IRAs and employer- sponsored retirement plans. First offered in 1998, Roth IRA contributions will still be subject to MAGI limits, phased out at $120,000 for single filers and $177,000 for joint filers in 2010. Married couples filing separately are phased out of eligibility to make Roth IRA contributions between $0 and $10,000.
In passing the tax-reducing components of TIPRA, Congress sought to limit federal revenue reductions to under $70 billion over the 10-year budget period. During that period, the Joint Committee on Taxation projected a tax revenue increase of $6.4 billion (present value) resulting from Roth IRA conversions. Interestingly enough, the Tax Policy Center (www.taxpolicycenter.org) estimates that real longer-term cost to the government will be more than double that amount, because of lower traditional IRA tax collections in future years. This alone suggests that Roth IRA conversions may provide taxpayer benefits well beyond their initial (or deferred) tax cost.
Roth IRA Overview
Funds contributed to Roth IRAs are not tax deductible. However, potential earnings accumulate tax-free and, after five years of participation and reaching age 59½, distributions are tax-free. Distributions of earnings before age 59½ are usually subject to a 10 percent excise penalty, in addition to ordinary income taxes. This means that you can always distribute your Roth IRA contribution amounts without tax or penalty. In the case of contributions comingled with converted funds, the annual contributions are considered distributed before converted amounts, then converted amounts (earliest first), and finally, earnings. Converted traditional IRA amounts distributed prior to five years or age 59½, whichever occurs first, also may be subject to a 10 percent excise penalty. Each amount converted begins its own five-year holding period, although the “clock” for earnings starts in the year that the Roth IRA is first funded.
Exceptions to the 10 percent excise penalty can be found under IRS Section 72(t). Exceptions include death, disability, first-time home buyers (up to a lifetime maximum of $10,000), medical insurance premiums for eligible unemployed individuals, medical expenses over 7.5 percent of AGI, IRS levy, qualified education expenses, qualified reservists, and amounts taken as a series of substantially equal periodic payments. While the 10 percent excise penalty for early distributions is waived on converted assets, it is not waived on amounts distributed from retirement plans to pay conversion taxes.
Unlike traditional IRAs, the Roth IRA has no age 70½ required minimum distribution (RMD). In addition, so long as the taxpayer has earned income, contributions can be made to a Roth IRA after age 70½, subject to MAGI phase-out limitations, as above. As a result, Roth IRAs can continue to grow over the life of the original owner and funds can continue to grow without required minimum withdrawals if the surviving spouse inherits the account.
In cases of a non-spousal beneficiary, Roth IRA distributions can then be stretched over the life expectancy of non-spouse beneficiaries so long as they begin distributions in accordance with the rules. In other words, the stretch opportunity is lost in cases in which the non-spouse beneficiary does not make required yearly minimum distributions within the mandatory periods.
5 Main Variables, 3 General Guidelines
Although the rules are clear, unknowable future events can create uncertainties in a conversion analysis. Numerous variables can factor in the ultimate economics of many conversion decisions that cannot be controlled or predicted at the outset. At the same time, it should be noted that for a simple economic benefit analysis, unless conversion taxes are being paid from another source, a conversion will yield a larger distribution amount (without other benefits) only if future distribution tax rates are higher than those at the time of the conversion. Note that other reasons to consider a Roth IRA conversion are described later in this article.
When addressing multiple areas of uncertainty, general rules can sometimes be helpful. In fact, many articles and advisers seem to capitulate and simply suggest making a partial conversion in an attempt to “hedge” the future.
There are five main areas in which a Roth IRA conversion analysis requires key assumptions. It is no coincidence that the typical online calculator requires inputs for these same five variables: (1) income needs, (2) life-expectancies, (3) portfolio returns, (4) conversion and distribution tax rates, and (5) source of the conversion tax payment. Because these variables can be interrelated, it can often be helpful to isolate and examine the three general guidelines described below.
Variable Time to Distribution
One of the more widely held general rules is that, the longer the interval before eventual distribution, the greater the expected benefit. Conversions are expected to be more attractive (with larger future values) in cases in which income needs can be met from other sources. In other words, to maximize the benefit of converting, the goal is to allow funds in the Roth IRA to grow as long as possible prior to distribution. Unfortunately, this rule can be misleading in more ways than one and, as shown below in the absence of other factors, it is usually valid only if conversion taxes are not taken from tax-deferred sources and the distribution bracket is close to or higher than the rate at conversion.
Absent income needs, the life expectancy of the owner can be used to project when funds might be distributed to the spousal and (eventually) non-spousal beneficiaries. Shorter life expectancies (that is, older owners and beneficiaries) will mean earlier distributions. Where the owner does not need income from the IRA and, barring premature death or asset invasion, using younger beneficiaries can provide a greater incentive for conversion. This assumes that younger beneficiaries will live longer, allowing longer distribution periods and larger future values.
Whether you view it as a “miracle of compounding” or the wisdom of tax-deferral, the underlying assumption is that Roth IRA assets will continue to grow if not distributed. Indeed, there are many Roth IRA calculators (Internet and otherwise) that simply extrapolate growth and, through a bar chart, graph, or spreadsheet, may appear to demonstrate that Roth IRA conversions can result in larger ultimate valuations and larger future distribution amounts. This leads to another error in the general rule that longer is better—the comparison of a dollar today versus a dollar in the future.
The time value of money concept tells us that a dollar today is more valuable than the same dollar at some date in the future. It is based on the assumption that money today can be invested and will grow to a larger amount in the future. To put a future Roth IRA conversion “windfall” into proper perspective, it is important to reduce the future income streams of both the traditional and Roth IRA to their present values. When computing present value of a single future amount or payment, there are four variables that must be identified. In the formula below, the variables are (1) present value PV, (2) future value FV, (3) interest rate i, and (4) number of periods n, as follows:
When analyzing the present value of a series of future payments, a financial calculator can be very helpful, especially in cases where there are uneven amounts or uneven distribution dates as is likely to be the case with IRA distributions. While the formulas for irregular periods and unequal distributions are beyond the scope of this article, the PV of a series of payments will be the sum of each distribution’s PV. In practice, one could simply perform PV computations on each future payment and then sum all of the resulting PVs to learn the cumulative present value of future cash flows.
Variable Portfolio Returns
In conformity with the goal of increasing the Roth IRA values through delayed distributions, increased return assumptions will also tend to favor the conversion decision. To provide potential conversion clients with a solid grasp of the importance of higher return expectations to the conversion decision, it can be helpful to consider various examples using lower and higher return assumptions. The following examples are based on a $100,000 traditional IRA with a starting and ending tax rate of 30 percent, and a 10-year holding period followed by complete distribution of the account.
Assuming a return of 2 percent per year, a conversion advantage exists if taxes are paid from an outside source. Even still, the advantage is minimal—about $2,096 after 10 years on a $100,000 conversion. In addition, the advantage can also be somewhat “fragile.” For example, if tax rates at distribution were to drop by only 2 percent, the advantage to the conversion would be erased and reversed:
Traditional IRA net of tax = $85,329
Roth IRA after conversion tax = $85,329
Roth IRA after conversion tax paid from alternate = $87,425
[FV cost of $30,000 conversion tax paid from alternate source at 1.4% (2% after-tax at 30%) for 10 years = $34,474]
Changing only the rate of return in the above example to 8 percent, the conversion advantage improves to about $13,000 and provides an advantage even if there is as much as a 5 percent decline in tax rates at withdrawal (if conversion taxes are paid from an outside source):
Traditional IRA net = $151,124
Roth IRA less conversion tax net = $151,124
Roth IRA after conversion tax paid from alternate source net = $164,160
[FV cost of $30,000 conversion tax paid from alternate source at 5.6% (8% after-tax at 30%) for 10 years = $51,732]
Variable distribution tax rates. As shown in the examples above, when distribution tax rates are higher than conversion tax rates, there will be an advantage even when the conversion tax is taken from the IRA. As also indicated, the advantage increases considerably when the conversion tax is taken from an outside source. In fact, assuming a constant tax rate, there is no advantage to converting if funds are taken from the IRA to pay the resulting conversion-related tax liability. When outside sources are used to pay taxes, the greater the annual return assumption, the longer the distribution delay, and the greater the tax is at distribution, the more the Roth IRA conversion will provide an advantage.
Strategic conversion uses. In contrast to the variable assumptions surrounding the Roth IRA conversion decision, there are also more controllable planning considerations that may make a conversion more desirable. These considerations include (1) estate planning, (2) asset protection, (3) other income tax considerations, (4) gift tax advantages, (5) estate tax mitigation, (6) enhanced portfolio growth potential, and (7) interaction with Social Security or other entitlement programs.
Estate planning. Because there is no state-level death tax on federal income taxes, payment of the federal income tax on a Roth IRA conversion can be useful to help lower state death taxes. In addition, the tax cost reduction to the overall estate can help mitigate federal estate taxes in otherwise taxable estates. For example, assuming a federally taxable estate in the 45 percent bracket, the effect of paying taxes for a Roth IRA conversion is to effectively “save” 45 percent of the amount of the income tax paid—which would otherwise be held and taxed in the estate. For these reasons, in the case of an impending death, a Roth IRA conversion may have even greater merit. It may also be advantageous to note that, although there is no federal income tax deduction allowed for state death taxes levied on IRAs, there is a deduction for the payment of federal income taxes. Note that if the IRA beneficiary is a charity, it will not be beneficial to convert a traditional IRA to the Roth IRA.
Asset protection. ERISA plans typically are considered exempt assets and immune from creditors in bankruptcy proceedings. In many states, this special federal protection is extended to include IRAs. In such a situation, it can be advantageous to use non-IRA funds to pay Roth IRA conversion taxes, rather than having those same funds attached by creditors. Because income tax payment has a priority payment position in a bankruptcy proceeding, taxpayers should take steps to assure that there will be sufficient non-IRA funds to pay the tax liability, or face the potential of being required to take IRA distributions to make good on the liability.
The federal Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCA) protects traditional and Roth IRA contributions and earnings from creditors in bankruptcy proceedings to a maximum limit of $1 million. BAPCA does not cap the exemption of rollovers from qualified plans, so rollovers are fully protected. The protection extends to all traditional, Roth IRA, and rollover IRA accounts and, in certain circumstances, can now make the IRA rollover an attractive area of discussion for those who may have left funds in their ERISA plan simply for the creditor protection. Also, it is important to remember that the anti-alienation provisions of ERISA and ERISA preemption continue to protect ERISA qualified plans from certain other creditors such as state creditor claims outside of bankruptcy. IRAs still do not have the same level of protection as qualified plans and are still subject to state creditor laws regarding malpractice, divorce, creditor, or other types of lawsuits.
Other tax considerations. Many taxpayers who have potentially valuable, but presently unusable tax deduction items can benefit from additional income. This category includes charitable deductions that are annually limited by the percentage of taxable income they can offset. Also included are tax credit carry forwards and flow-through tax entities with net operating losses and insufficient ordinary income to deplete them. In these cases, the Roth IRA conversion may have special attractiveness.
The same ability to offset taxes due on conversion amounts can be used to balance charitable contributions in excess of current-year deductible amounts. Because unused charitable deductions do not survive the death of the taxpayer, this strategy can be especially valuable in cases where the deduction carry forward may be at risk because of an impending death. The ability to offset Roth IRA conversion taxes with charitable deductions can also add economic benefit to techniques such as charitable remainder trusts and charitable lead trusts by allowing the deduction to be used up sooner rather than carried forward.
Other use-it-or-lose-it tax deductions, including annual medical deductions, are contingent on the taxpayer attaining certain income levels and can also make a Roth IRA conversion more attractive. Also, because Social Security benefits can be taxed when income levels exceed certain amounts, converting to a Roth IRA may allow those benefits to avoid taxation by avoiding the receipt of taxable income resulting from RMDs or voluntary distributions from traditional IRAs. However, in the year of conversion, this strategy may have a negative effect on clients already receiving Social Security or other potentially taxable benefits.
2010 Tax Deferral
For the payment of taxes on 2010 Roth IRA conversions only, taxpayers can either choose to pay all federal income taxes due on the conversion in 2010 or they may defer 2010 income recognition to 2011 and 2012. Under this election, a taxpayer may elect to report half of the income in 2011 (tax due April 15, 2012, or October 15, 2012, with extension) and the other half in 2012 (tax due April 15, 2013, or October 15, 2013, with extension). This could allow 28 months before the first tax payment is due and 32 months before the second tax payment is due for conversions made in January 2010. Although the taxes are paid at the then-prevailing rates, the choice will be made easier because the 2011 tax rates should be available before the 2010 filing deadline. In addition, if the converted funds are withdrawn before 2013, the tax due to the conversion may be accelerated.
Because conversions also may be made over multiple tax years, a potentially valuable planning opportunity will still remain after 2010. The logic involved in converting in 2010 also applies to the recommendation that the conversion occur earlier in the tax year. The earlier conversion allows the assets (presumably) to grow for a longer time in the Roth IRA account.
The taxation of the conversion will depend on the pro rata rule’s ratio of before-tax to after-tax amounts. In cases where pre- and post-tax contributions were made or rolled over to a taxpayer’s aggregate traditional IRA accounts, the pro rata rule measures the proportion of those contributions and assigns a factor to compute the taxable amount of a distribution attributable to pre-tax funds.
Recharacterization and Re-Conversions
Conversion earlier in the year also gives taxpayers more time to take advantages of an opportunity known as “recharacterization.” Recharacterization allows investors to undo a conversion and eliminate the attendant tax liability by moving the funds back into the traditional IRA.
Recharacterizations must be completed by the due date of the federal income tax return, including automatic extensions. Generally, taxpayers will wish to wait at least until the end of the conversion year before deciding to recharacterize. The timeframe gives taxpayers converting in January up to 21 months to reflect on the wisdom of the conversion. Re-conversion (back to the Roth IRA) is permitted after the later of 30 days, or January 1 of the year following the conversion. This prohibits re-conversions of the same amounts from occurring in the same tax year. Note that, in the case of a partial conversion, the unconverted amount remains eligible for same-year conversion, even when there is a re-conversion of a different conversion amount.
Partial Conversions and Recharacterizations
Because the future tax rates are not known until published, a partial conversion may be an attractive choice that also allows flexibility for future conversions. In the case of full re-conversions of the entire Roth IRA balance in an account, no gain/loss calculation is needed. However, for partial recharacterizations, the amount recharacterized must include the gain or loss experienced while the converted funds were in the Roth IRA account. This amount, known as the net income attributable, must also be transferred back to the traditional account.
For example, if $100,000 were converted to a Roth IRA and earned 10 percent, recharacterizing half ($50,000) of the original conversion will require a transfer back to the traditional IRA of $55,000. Similarly, if the performance while in the Roth IRA were negative, the amount of the partial recharacterization would be less than the pro rata portion of the original conversion. The IRS, in T.D. 9056 (Earnings Calculation for Returned or Recharacterized IRA Contributions), provides the following formula for determining gain/loss:
Net Income = Contribution × (Adjusted Closing Balance – Adjusted Opening Balance) / Adjusted Opening Balance
Receipt of negotiable funds by the taxpayer, even temporarily, may trigger disallowance of the recharacterization or a failed conversion. Care should therefore be taken to ensure trustee-to-trustee transfers for conversions and recharacterizations. A failed conversion is considered a traditional IRA distribution and can trigger both federal income tax and a potential 10 percent excise penalty. A failed reconversion can be treated as an excess Roth IRA contribution and may trigger the 6 percent penalty tax assessed on excess Roth IRA contributions that remain in the Roth IRA following the tax return due date (including extensions).
The penalty for excess Roth IRA contributions is assessed each year that the excess amount remains in the Roth IRA. To keep the audit trail “clean” in the case of a recharacterization, it may be helpful to establish a separate Roth IRA account, at least temporarily, to avoid comingling converted assets with prior Roth IRA investments. Where the partially converted account also contains non-deductible contributions, the unconverted remainder will keep the same ratio of deductible vs. non-deductible assets as existed prior to the partial conversion in aggregate in all traditional IRA, SEP, and/or SIMPLE plans.
Bracket creep, phase outs, and Social Security. Distributions from traditional IRAs, including conversions to a Roth IRA, are taxable events. The additional income from a distribution may push the taxpayer into a higher marginal tax bracket. With the higher income level attributable to conversion proceeds, there may also be a phase-out of certain otherwise allowable deductions, resulting in additional tax costs and the so-called “Stealth Tax.” To avoid surprises, do the math first.
As above, a Roth IRA conversion may mean a lower tax on future Social Security benefits because Roth IRA distributions are not includable in income. On the other hand, because the taxable portion of traditional IRA distributions (and conversions) is considered income, Roth IRA conversions may have unintended tax consequences for those already collecting Social Security. The amount of Social Security benefits that is subject to taxes may increase if modified AGI exceeds the base amount. In 2010, the base amounts are $32,000 for married couples filing jointly and $25,000 for single filers.
Estate Planning Opportunity
Roth IRA owners and surviving spouses who inherit the account are not required to take (RMDs). Non-spouse beneficiaries of Roth IRAs should begin RMDs the year following the year of death of the IRA owner to take advantage of the stretch IRA strategy that allows distributions to be taken over their (presumably longer) life expectancy. As a result, significant accumulations may be transferred to future generations.
In contrast, owners of traditional IRAs must take RMDs every year by April 1 of the year following the year they obtain 70½. If the first year’s RMD is delayed until April 1 of the following tax year, it effectively defers the tax for 12 months, but also requires two RMDs to be due in that same year. Taxation of traditional IRA distributions will depend upon the ratio of pre-tax and after-tax contributions known as the pro rata rule.
Regardless of whether RMDs had begun, a spouse named as beneficiary stands in a unique position as compared to non-spousal beneficiaries. A spousal beneficiary may roll the traditional IRA into his or her own name, and is only required to take RMDs upon reaching age 70½. In addition, spousal beneficiaries can use the IRS Uniform Table to determine each year’s applicable divisor, which may result in a longer distribution period than the single-life table.
Non-spouse beneficiaries do not have the ability to roll over the IRA they inherit to their own IRA. If they decide to keep the inherited IRA, the IRA custodian must title the account to distinguish its origin as an “inherited” or “beneficiary” IRA. If the non-spouse beneficiary plans to take advantage of the stretch IRA strategy, he or she must take RMDs by December 31 of each year, beginning with the year following the IRA owner’s year of death. These beneficiaries will use the Single Life Table (Term Certain), which bases distribution amounts on the age of the beneficiary in the year following the year of the IRA owner’s death. That life expectancy is then reduced by one in each subsequent year.
If RMDs are not taken by December 31 of the year following the IRA owner’s year of death, and the IRA owner died before their required beginning date (RBD), then the IRA account would need to be fully distributed before five years to avoid penalties. If a traditional IRA owner dies after their RBD, there is no five-year option and any distribution missed will be subject to a 50 percent penalty on the amount not distributed. A deceased Roth IRA owner is always treated as having died before their RBD and the five-year option is always available. A beneficiary who has missed an RMD should consult with a tax professional to determine the best course of action.
Pay Taxes from Non-Retirement Plan Assets
The economic merit of a Roth IRA conversion usually requires the present value of the tax-free growth in the Roth IRA to offset and exceed income tax paid for the conversion opportunity. Usually, the longer funds can remain in the Roth IRA, the greater the benefit. Additional factors influencing the conversion decision include the expected investment returns and the tax rate at conversion versus the tax rate at distribution. It will usually be best to pay the Roth IRA conversion taxes from non-IRA assets. This allows a larger amount to benefit from long-term tax-free growth potential.
Converting Other Assets
Tax consequences of conversion with large rollover accumulation. Beware of a potential conversion trap arising from same-year employer plan rollovers.
As with non-Roth IRA distributions, the pro rata rule provides that conversion taxation is based upon the proportional share of deductible contributions, non-deductible contributions, and account earnings.
For example: Assume an investor has a traditional IRA balance of $100,000 that includes $50,000 in non-deductible contributions. The investor wants to convert during the year and believes that taxes will be owed only on $50,000. However, after the conversion, but in the same tax year, a $400,000 401(k) plan rollover is made into a traditional IRA for that investor. Suddenly, the taxable portion of a $100,000 conversion is 90 percent ($90,000). If instead, the 401(k) rollover were delayed until the following year, the taxable portion of the current-year traditional IRA conversion would be only 50 percent ($50,000). This is because of the pro rata rule that aggregates all SEP, SIMPLE, and/or traditional IRA values on December 31 of the year of conversion to determine the taxable vs. non-taxable ratio of a conversion.
To avoid this problem, consider waiting to roll over employer-sponsored retirement plans until a year after the Roth IRA conversion. If an employer plan rollover has already been made, depending upon the terms of the plan, it may also be possible to transfer it back before December 31 of the rollover year. Because plan rules can vary, it may be necessary to refer to the administrator or the plan document to confirm that incoming rollover contributions are allowed.
401(k) Plan or 403(b) Annuity Conversion to Roth IRA
Employer-sponsored plans have different rules than IRAs for keeping track of after-tax amounts. The plan administrator is responsible for keeping track of the assets and can distribute them without using the pro rata rule. This means that a distribution of pre-tax money may occur separately from after-tax amounts. The Pension Protection Act of 2006 allows company plan balances to be converted directly to Roth IRAs.
Conversions from employer-sponsored plans can be made by direct rollover of before-tax and/or after-tax money from the plan to the Roth IRA. In addition, amounts can be distributed from the plan and rolled over to the Roth IRA within 60 days of the distribution date. Pre-tax amounts that are converted will be included in the IRA holder’s gross income for the year but Roth IRA conversion of after-tax amounts will not be taxable income. In each case, the amount rolled over must be an eligible rollover distribution.
Keep in mind that when receiving a direct distribution (not a rollover) of pre-tax amounts from an employer plan, the plan is required to withhold a mandatory 20 percent for federal taxes. Applicable taxes and penalties on the amount of the rollover contribution can be avoided if the entire amount of the lump-sum distribution is deposited into an eligible retirement account within 60 days of receipt. If the 60-day deadline is missed, the entire taxable portion of the distribution will be included as income and there may also be a 10 percent tax penalty, depending on age and the reason for the distribution.
In rolling over the total distribution amount (including withholding), the investor must personally deposit (out of pocket) the 20 percent tax withholding that was deducted from the distribution. Any taxable portion not rolled over (including the 20 percent tax withholding) will be considered a taxable distribution and income tax will be owed (on the taxable portion of the distribution) plus a 10 percent penalty, if under age 55. Some states may require withholding of taxes as well.
Some Tips
- For very large plans, consider a separate Roth IRA for each asset class. This gives the investor an opportunity to selectively recharacterize those classes that decline in value and to keep the conversion for those that increase in value.
- For indecisive clients, consider converting a small amount, say $100, to begin the tolling of the five-year Roth IRA period for earnings. Be aware of account fees that may result from low balances.
- For clients whose IRA distribution contains only after-tax dollars, conversion is a logical choice because taxes will only be due on gains (if any) in the account. Be aware of the pro rata rule.
- For clients with both after-tax and deductible IRAs, a rollover of the taxable IRA amounts into an employer-sponsored plan may be an attractive way to separate the non-taxable dollars for conversion into a Roth IRA without triggering the pro rata rule. The removal of pre-tax contributions from a traditional IRA can leave only post-tax contributions and their earnings remaining in the traditional IRA. This occurs because employer- sponsored plans do not permit rollovers of post-tax amounts and a calculation must be made to ensure that only pre-tax funds and their earnings are transferred into the employer plan. Again, employer plan rollover provisions can differ and should be checked in areas such as availability, distribution access, investment options, beneficiary provisions, etc.
- Deathbed conversions may be especially attractive, and even more so for those with taxable estates. Conversion is not advised for IRAs having only charitable beneficiaries.
Takeaways
The Roth IRA conversion MAGI limits and tax filing status eligibility are eliminated beginning in 2010. Conversions are most effective when taxes are paid from outside sources, future tax brackets are higher, and distributions are delayed as long as possible. Conversions may cause bracket-creep and can affect both itemized deductions and Social Security income. The 10 percent early distribution penalty is waived on converted amounts, but not waived on amounts taken from traditional IRAs to pay conversion taxes.
Conversions are best made early in the year and must be completed by December 31 of the converting tax year. All conversions offer recharacterization opportunities including the opportunity to respond to miscalculations, changes in income, or to take advantage of market declines prior to tax filing deadlines. Special issues may arise in the case of concurrent employer retirement plan rollovers and qualified annuity conversion valuation. Conversion decisions should be based upon careful calculations and may not be the best alternative for everyone.
The opinions herein are those of the author and not of Wells Fargo Advisors LLC. Wells Fargo Advisors LLC has not made any independent verification of the information contained in this article or the sources of the information. As with any investment, legal or tax matter, competent counsel should be consulted prior to initiating action as Wells Fargo Advisors is not a legal or tax advisor.
Wells Fargo Advisors LLC, Member SIPC, is a registered broker-dealer and separate nonbank affiliate of Wells Fargo & Company.
Investment and insurance products: NOT FDIC-Insured, NO Bank Guarantee, MAY Lose Value.
Sidebar
Roth IRA Features
- No required minimum distributions (RMDs) for those 70½ or older
- No limit on the amount that can be converted
- No limit on the number of conversions
- Ability to recharacterize until the latest tax filing date, including automatic extensions
- Potential tax-free compounding of earnings
- Potential tax-free income distributions for the Roth IRA owner and his or her named beneficiaries
- Potential tax-free wealth accumulation for heirs
- Ability to defer and spread conversion taxes over two years (for 2010 conversions only)
If you have any questions or concerns regarding this article, please send comments to JFPfeedback@fpanet.org
