Revealing the Rewards and Ramifications of the Roth IRA Conversion
The Tax Increase Prevention and Reconciliation Act of 2005 was signed into law by President George W. Bush and allows nearly $1.4 trillion of assets on January 1st, 2010 to be eligible to be converted to a Roth IRA¹. The current tax laws prevent anyone with adjusted gross income over $100,000 to contribute funds to a Roth IRA. As of 2010, the gate that separated these higher-earners from contributing to a Roth was lifted and the benefits that come with the Roth IRA will be given to those that financially should perform the conversion.
What's the difference?
In the case of a Traditional IRA, money is deposited in an investment account that potentially grows those assets, tax-deferred, until they are withdrawn in retirement or passed on to a beneficiary. Once retirement age is reached, the assets in the IRA must be taken out per Required Minimum Distribution (RMD) guidelines and taxes must be paid each year on each RMD. Since income taxes are paid prior to investing in a Roth, earnings accumulate tax-free; moreover, the accumulated value of a Roth is never taxed. RMDs are also not required to be taken with a Roth IRA, which allows the assets to continue to grow, permitting wealth to be accumulated and preserved.
According to Bill Donoghue, a financial author², "You will never retire on the money you save for retirement; you will retire on the money you make on the money you save for retirement." The idea of having the ability to not take distributions while allowing the account to continue to build upon itself can open the door to further financial opportunities.
What Are The Other Benefits to a Roth IRA?
There are numerous benefits to contributing to a Roth IRA, they include: Social Security planning, emergency reserve funding, tax diversification, and estate planning.
Social Security Planning
When benefits are taken from Social Security (S.S.), modified adjusted gross income (MAGI) is considered when evaluating the tax implications of the benefits, this includes all sources of taxable income. Examples of these types of income include: income received from any pension a consumer may have, withdrawals taken from a Traditional IRA and/or 401(k) as well as one-half of Social Security retirement income. Only when a married couple's MAGI is under $32,000 ($25,000 for an individual) are S.S. benefits tax-free. Half of S.S. benefits are taxed when a couples MAGI is between $32,000 and $44,000 (between $25,000 and $34,000 for an individual), and if the total income exceeds $44,000 ($34,000 for an individual) then 85% of the benefits are subject to taxes. With a Roth IRA, the distributions taken from the account are not included in the MAGI for social security purposes, allowing the opportunity for less taxes to be paid on S.S. benefits.
It is important to note that if the income being taken from other sources, outside of a Traditional IRA or Roth IRA, exceeds the highest threshold then the Social Security tax savings provided by a Roth IRA conversion will naturally not occur. Of course, due to the large amount of reportable income that will occur during the year the conversion taxes are paid, this S.S. tax savings strategy will not take place since the individuals MAGI will likely be above the maximum threshold.
Emergency Reserve
Unlike a Traditional IRA, principal that is in a Roth IRA may be withdrawn anytime penalty-free and tax-free as long as it is a qualified distribution. To make a withdrawal of interest from the account it must still be qualified and can not take place until after five years of the initial conversion. One strategy that can be used with a Roth IRA is treating the account as an emergency reserve. If a consumer does not have life insurance or long-term care insurance and has chosen to self-insure, then a Roth can be an excellent way to set aside that money. This allows it to grow tax-free while still keeping it liquid, in case an emergency does occur. Medical expenses can be one of the largest a person may sustain during their lifetime, which is why it is essential to understand the significance of having money, whether in the form of insurance or in a liquid account, available to be used in an urgent situation.
Tax Diversification
We all know the value of having a well-diversified investment portfolio; the movement of tomorrow's stock market is unknown today. Just like these investments, it is important to have diversified tax accounts since future tax rates are unknown. With the growing amount of monies being used to prop up the U.S. economy and financial industry, it is likely funds will be raised via taxes in order to bring down the federal budget deficit that currently comes in at an all-time high of $1.42 trillion as of September 30th, 20093. Because of these factors, it may be wise for a person's financial future to be separated between tax-deferred accounts as well as tax-free accounts, hedging their plan for tax rate increases and/or decreases. A married couple in 2009 who needs $100,000 a year to live on could take up to $79,300 in income and still be in the 15% tax bracket. Under the benefit of a Roth which provides tax-free income, this same couple could take an additional $21,700 and meet their $100,000 plan while still remaining in the 15% bracket.
Legacy Planning
Individuals with larger estates who plan to pass on assets to their children or other heirs need to evaluate the tax consequence of this transfer. In the instance of a Traditional IRA, the heirs of that account will be required to pay income tax on required withdrawals after they receive the "inherited IRA". The obvious advantage is that the Roth IRA distributes income, tax-free, to their heirs. Since assets that would be includable in the "converter's" estate are used to pay the conversion tax, thereby reducing the owners taxable estate, the Roth conversion itself is estate tax efficient.
A common vehicle used for passing assets onto heirs is a trust. With a trust, once the income exceeds $11,150 for 2009, distributions from taxable retirement accounts will be taxed at the highest marginal income tax rate, 35%. If the purpose of the trust is to grow the assets for long-term and protect them against beneficiaries' creditors and spendthrift behavior, then using a Roth IRA inside the trust while paying the taxes now, at a possible lower rate, will allow the beneficiaries to take distributions later, tax-free.
Both a Traditional IRA and a Roth IRA allow a beneficiary of the account to stretch the distributions over their lifetime, only taking the RMDs from the account each year. One advantage the Roth has, pertaining to stretching the distributions, is the undistributed assets within the Roth IRA can continue to be invested and grow tax-free compared to just tax-deferred over the beneficiary's lifetime. For example, a father, age 70, with a $100,000 IRA would like to leave the account to his son who is 45. The father took his RMDs from the IRA, the account grew at 7%, assume he died at age 90 and his son stretched the distributions for his lifespan, the son would take $260,512 in distributions from the Traditional IRA. If he had converted to a Roth IRA prior to death and paid the taxes associated with the conversion using non-qualified funds, the father would not be required to take distributions during his lifetime. His son would then take $856,182 in stretched distributions, a 30.4% difference compared to what the son would have taken in distributions from the Traditional IRA.
If an individual is considering gifting the IRA to a charity at death, then a Roth IRA may not be the best strategy. Since charities are not required to pay income taxes, there is no need for the account to grow tax-free with the consumer paying the conversion tax prior to the donation. There are other investment and distribution strategies that could be better suited for this type of situation and should be discussed with a financial adviser.
The Decision
The conversion from a traditional retirement account to a Roth account does not come without obligations. A decision must be made whether one believes income taxes will be higher or lower upon the time funds are withdrawn from retirement accounts. A second consideration that must not be overlooked is how the conversion will be paid for. In order to convert to a Roth IRA, income tax must be paid on the assets transferred. A strong preference is to not use funds from the account to pay the tax but rather use other non-IRA monies. Since a large increase in reported income is likely, a tax professional should be consulted about the potential change in the individual’s tax bracket and proper considerations of any other tax ramifications.
One benefit in converting to a Roth in 2010 is the ability to pay the income tax either as a lump sum in 2010 or split it equally between 2011 and 2012 taxable years, allowing a smaller tax burden increase due to the conversion. This split of taxable income between the two years is only allowed for conversions made in fiscal year 2010. It is important to note that the tax rate for the 2011 and 2012 years is currently not known and will likely change from the rate in 2010 and may impact the transaction.
The information provided is for general reference only. Roth IRA Conversions may create complex tax and tax related issues. Your individual situation may differ from examples shown. Please consult with a qualified tax professional before executing a conversion. Founded in 1997 by David Holland, Holland Financial is a financial services firm providing Retirement Planning, Investment Management, and Wealth Management services to retirees and pre-retirees in Central and North Florida.
References
- Investment News 1/30/2009
- Market Watch 10/11/2007
- Forbes 10/16/2009
