Changing the Game: A Look at the New Roth IRA Conversion Rules - Part 2

Tom Magnor, CPA, Tax Senior   email
January 2010

Effective January 1, 2010, the adjusted gross income (AGI) limitation for converting traditional Individual Retirement Accounts ( IRAs) into Roth IRAs will be eliminated and provide a significant tax planning opportunity for many taxpayers. The December issue of The Adviser featured Part I of a two-part series on Roth IRA conversions.  The fundamentals of traditional and Roth IRAs and the tax laws concerning the new Roth IRA conversion rules were discussed.  This article will present factors to consider when evaluating a conversion and discuss some of the benefits of converting to a Roth IRA.

Should You Convert?

The question of whether or not to convert depends on a variety of factors and assumptions.  Among others, these variables include current tax rates, expected future tax rates, the current IRA balance, and tax conversion costs.

The analysis of converting is very complex; however, the use of a simple example best illustrates one of the advantages of converting a traditional IRA to a Roth IRA.  Mr. and Mrs. Smith are both 40 years old, plan on retiring at age 65, and have $500,000 in a traditional IRA. In addition, they have $175,000 in an investment account available for paying the tax on a Roth IRA conversion.  The Smiths are currently expecting an average of 8 percent return on their investments for the next 25 years. They are currently in the 35 percent income tax bracket and expect to be in the same bracket when they retire.

While the Smiths will incur a $175,000 tax liability up front on a Roth IRA conversion, they (or their heirs) are projected to incur $1,198,483 by 2035 in federal income taxes upon withdrawal of the IRA funds without a conversion.  The Smiths will ultimately accumulate $576,997 more in wealth by converting to a Roth IRA. Additional accumulation of wealth would be magnified if future tax rates increase.  The benefit of the conversion is highlighted in the chart below.

The numbers from the above analysis illustrate the benefit of allowing Roth IRA assets to grow tax free.  One disadvantage of a traditional IRA is the Required Minimum Distribution (RMD). Once an owner of a traditional IRA reaches age 70½, distributions are required based upon life expectancy.  RMDs will decrease the traditional IRA's account value, resulting in an income tax liability and limiting future growth potential. A Roth IRA, on the other hand, is not subject to RMD rules and will continue to grow tax free.

While the Roth IRA conversion would generate additional wealth for Mr. and Mrs. Smith, that is not always the case. Many other variations and assumptions should be analyzed before converting.  In the example, Mr. and Mrs. Smith paid for the conversion with non-IRA funds.  Paying the Roth IRA conversion tax from assets outside the IRA significantly leverages the benefit of the conversion.  Had Mr. and Mrs. Smith paid the conversion tax out of the IRA, their wealth accumulation would be significantly reduced.

Wisconsin Tax Considerations

State taxes are another factor that should be addressed.  As mentioned in Part I of this article, Wisconsin has not adopted the new federal rules regarding Roth IRA conversions.  This is a priority for Wisconsin legislature beginning in January 2010.  Until Wisconsin adopts the federal provisions, a conversion may result in penalties if taxpayers convert before reaching age 59½.  While our example only accounts for federal income taxes, state income taxes could have a significant impact on whether or not a Roth IRA conversion is beneficial.

Recharacterization

Taxpayers have the ability to recharacterize their Roth IRA conversions. Recharacterizations allow taxpayers to, in effect, undo the conversion.  Taxpayers have until the extended due date of individual tax returns to make a recharacterization. For example, Mr. and Mrs. Smith convert their $500,000 traditional IRA to a Roth IRA on January 1, 2010.  During the summer of 2010, the stock market performs poorly, and the converted assets decline in value to $350,000.  While their Roth IRA is valued at $350,000, Mr. and Mrs. Smith will need to pay the tax on the full $500,000 original conversion amount.  Recharacterizations allow Mr. and Mrs. Smith to undo the conversion and avoid including the conversion in their adjusted gross income.

"Cherry Picking" and Asset Allocation

Before performing a conversion, taxpayers should review their current asset allocation and consider dividing their holdings into different asset classes (e.g. specific investment holdings, investment styles, industry sectors, market cap size, etc.). Taxpayers may then convert each of these asset classes into separate Roth IRAs.  If one asset class doesn't perform well, then taxpayers have the ability to "cherry pick" the Roth IRAs they would like to recharacterize.  It should be noted that taxpayers cannot recharacterize a specific asset from a single Roth IRA.  By separating the assets into multiple Roth IRAs, taxpayers create greater flexibility.

The change in Roth IRA conversion rules allows taxpayers to plan for their retirement with greater flexibility. Roth IRA conversions and recharacterizations are complicated transactions, and this article has only touched on a couple of the factors to consider in evaluating the benefits of a conversion. Professional advice should be sought to determine whether your situation would benefit from a Roth IRA conversion.  If you would like more information, please contact Tom Magnor at 262/754-9400 or tmagnor@KolbCo.com.