PRM Consulting Group

Author: Tom Rand, Principal
April 2010

The Roth IRA — to Convert or not to Convert?

Roth IRAs have been around since they were first established by the Taxpayer Relief Act of 1997. Because of the income limits that applied, they have not—until now—been of much interest to executives and affluent taxpayers, since they could not qualify to make contributions to a Roth IRA.

Under the oddly titled Tax Increase Prevention and Reconciliation Act of 2005, however, the Congress has changed the game, so that one of the hottest current topics among financial planners and those who need their services is this: does it make sense to convert my Individual Retirement Account (or accounts) to a Roth IRA Account?

The Congress substantially sweetened the pot for such conversions in 2010 in three important ways:

  • First, under TIPRA 2005, the Adjusted Gross Income limit for taxpayers wishing to convert an IRA to a Roth IRA was removed. For 2009, that limit was $100,000—with no limit they are now open to taxpayers at all income levels.

  • Second, for taxpayers who elect to convert in 2010, they have the option of paying the tax due with their 2010 return. In the alternative, they can pay one-half the tax due on the conversion when they file their 2011 tax return and the balance with their 2012 return.

  • Finally, taxpayers who convert will be permitted to re-characterize their conversion so long as they do so before they have filed their tax returns for 2010, including all extensions. In effect, taxpayers will be able to void the conversion and recover any taxes they may have paid. And if they do so, they will still be able to reconvert, so long as they do so at the later of:

  • The first of the year following the year in which they converted, or

  • 30 days after the date that they elected to re-characterize the conversion.

The net effect is to permit a “do-over” if for any reason taxpayers wish to retract their earlier decision to convert and a further do-over if they wish to undo the retraction by converting again.

These changes have obvious implications for affluent taxpayers (and potentially for their heirs) and some that are not so obvious. The purpose of this newsletter is to offer our clients and other interested readers some information about both sets of implications, and to illustrate how careful analysis is required to determine whether such a conversion might make sense for you. That includes especially the tax issues—and questions—that we believe make such an analysis both thorny and essential.

At First Blush

At first blush (or for that matter, at second or third or fourth) it is simple to construct an argument that the conversion really doesn’t matter much, if at all, from the standpoint of an individual’s eventual net worth. Stated another way—if the taxpayer pays the taxes currently due on the conversion, or pays the taxes due later when he withdraws the money from the account, absent changes in his marginal tax rate he ends up at the same place. A simple example serves to illustrate.

Assume that an individual has $1,000,000 in a traditional IRA that is eligible for conversion. Assume further that the taxpayer’s marginal tax rate (including state taxes) is 40% and would apply to the full $1,000,000 which is being converted. And that the individual will pay the taxes out of the traditional IRA, investing the balance in the Roth IRA on which no further income taxes will be due. Finally, assume that the taxpayer’s marginal tax rate will not change in the future.

Thus, the taxpayer has $600,000 in the Roth IRA after the conversion ($1,000,000 less taxes of $400,000). If he earns 7% annually on the account, the amount will double in approximately 10 years, to $1,200,000.

But if he never converted at all, the full $1,000,000 would remain invested within the traditional IRA. If the earnings were 7% per year, at the end of the same 10 year period the assets would be worth $2,000,000. If all the assets were withdrawn at that point the proceeds after taxes would be the same $1,200,000 after payment of the 40% that would then be due in income tax.

So in the absence of essentially unforeseeable changes in income tax rates, the effect of a conversion on both the taxpayer and his heirs, positive or negative, is difficult to discern.

However, there are other tax and other issues that come into play, that make the careful analysis required and ultimately the judgment whether to convert or not more complicated and potentially much more important.

The Tax Bet

As we see it, one of the most intriguing reasons to consider converting has to do with the country’s current and projected financial situation, particularly the level of today’s and tomorrow’s deficit, national debt and the structural imbalance between entitlements and projected revenues to fund those entitlements.

Economists and politicians on both sides of the aisle readily concede the obvious and accurate fact—that the county’s current fiscal course is “unsustainable.” So if you concur with that judgment, you accept the more or less inevitable conclusion that correcting that course, over time, will require among other potential changes more revenues, i.e. more taxes. But the difficulty of making judgments about what income tax rates are likely to be, not just in a few years but ten years or more into the future, can hardly be overstated.

If, for example, a part of the corrective action that will ultimately be required entails the adoption of a value added tax or some other broad-based tax on consumption, it is not at all impossible that marginal income tax rates might even be scaled back.

So in the end, individuals contemplating conversion because they believe that their personal income tax rates may go up in the future have some grounds for that belief—but that conclusion should be tempered with the recognition that the certainty ascribed to death and taxes most assuredly does not apply to the ultimate tax rates that may apply to the proceeds withdrawn from a traditional IRA that has been converted to a Roth IRA, particularly if such withdrawals are going to be deferred for a very long time.

A more immediate tax bet is also in play. While it’s not certain amid today’s turbulent political climate, it seems to us more likely than not that the Bush income tax cuts will be allowed to expire based on current law in 2011. If that happens, the top marginal rate (which will generally apply to Roth IRA conversions or at least those of any magnitude) will increase from 35.0% to 39.6%. That’s an increase in the tax rate of more than 13%. Or looked at another way, while it’s generally considered advantageous to defer paying taxes, in this instance the decision to do so would have the same effect as if the taxpayer borrowed money from the Treasury at an effective annual interest rate of 8.6%.

In Graph 1 below, we show the difference between the amount of taxes that a taxpayer is required to pay for 2010 at the current top marginal rate of 35% on a conversion of $1,000,000, versus the amount he’s required to pay in total for 2011 and 2012 if he defers payment under the terms provided in the statute, assuming the Bush tax cuts will expire at the end of this year.

There is another risk associated with the decision to defer paying taxes until 2011 and 2012. That risk is that the current version of health care reform proposed by President Obama will become law. In that event, the Medicare tax on unearned income (e.g. capital gains) that was substituted to pay for deferring the tax on so-called “Cadillac” health plans until 2018 will potentially add another significant tax burden triggered by delay, if the taxpayer wishes to sell assets from outside his traditional IRA balance to generate the cash to pay the taxes. We discuss issues related to this question more fully in the next section of this newsletter.

But happily here as elsewhere—though perhaps inadvertently—the Congress has loaded the dice in the taxpayer’s favor. Since you do not have make the decision to pay the taxes for a 2010 conversion until those taxes are due—with extensions—you will know for sure whether those tax cuts now scheduled to expire at the beginning of 2011 will in fact have done so.

Other Important Tax—and Other—Issues

For affluent taxpayers, it is probably reasonable to assume that they will be at or near the maximum marginal tax rates both now and in the future, especially if they have no plans (and no need) to scale back significantly their consumption and standard of living as the years go by.

Nonetheless, there are some other issues and wrinkles that are important to mention for anyone contemplating this decision. Among these are:

  • Is your income going to be unusually low in 2010? This is unlikely to be a factor for affluent taxpayers but it could be. If that’s the case compared with future years, there could be some advantage in paying the taxes on the conversion at your current lower rate, but keep in mind that two factors have to be in play:

  • First, your income has to be low enough so that you’re relatively certain that it will revert to higher levels (and therefore higher marginal rates) in the future.
    • Second, the amount you can convert and benefit from the current, lower rate you expect to pay would also have to be relatively modest—otherwise the additive income from the conversion could eliminate any such benefit.

  • Don’t forget about the Alternative Minimum Tax. This is an especially important issue which we have not seen discussed in other publications we’ve reviewed on this topic. It is also perhaps the most vivid illustration about how the complexities of our current tax code can complicate this decision in ways that call for very careful analysis. Here is how the issue presents itself in practice.

  • Most affluent individuals have multiple sources of income and deductions, including preference items that are subject to the AMT. These tax preference items include state and local taxes, accelerated depreciation, certain itemized deductions, credits and exemptions, and, under exemption phase out rules, long term capital gains.

    • For a taxpayer whose tax situation will bring the AMT calculation into play, the AMT calculations can significantly increase the rate at which long term capital gains are taxed. Those gains are nominally taxed at just 15% at the Federal level. But the AMT calculations can increase the tax to as much as 28%. Moreover, because the AMT exemption begins phasing out at a rate of 25% at $150,000 of AMT Minimum Income (AMTI) for taxpayers filing joint returns, that phase out can increase the marginal tax rate for the taxpayer to as much as 35%, if his AMTI is between $150,000 and $415,000 (the dollar amount at which the phase out ends).

The maximum potential effect on a taxpayer is illustrated in Graph 2 below.

So why does this matter? It matters because many taxpayers will not have the amounts required to pay the taxes generated by the Roth conversion in cash, and thus will have to sell assets to raise that cash. And while the sale could be made from assets held in the traditional IRA that’s being converted, that transaction diminishes the efficiency of the conversion over time in increasing the taxpayer’s net worth compared with just maintaining the traditional IRA. This occurs because those amounts are subject immediately to ordinary income tax. In addition, the taxpayer has shielded only the amount remaining after the sale of those assets from the Required Minimum Distributions after age 70½, compared with shielding the full balance being converted by paying the taxes with cash from outside the IRA.

Thus the taxpayer will be presented with the question: which assets should I sell? The intuitive (some would say knee jerk) reaction of most taxpayers is to sell assets outside the IRA with a higher basis so as to minimize the capital gains tax.

The obvious argument to the contrary is that the current Federal rate of 15% on long term capital gains is among those items in the gunsights of those in the Congress who want to raise taxes, so realizing gains now rather than in some future year may be in the taxpayer’s interest. But the less obvious—and in many cases much more important—reason to consider selling lower basis assets is the effect of the AMT calculations. Because the conversion itself can generate a very large additive amount of ordinary income, in many cases the taxpayer will find that the additional taxes that otherwise would be levied on the realized gain will be moderated, or even eliminated, because of the conversion.

At the maximum, the tax savings could be as much as 20% on the realized gains, effectively paying for as much as half the taxes that are otherwise due on the conversion.
The AMT provisions and calculations can even make a difference where an individual has very limited preference items. Let’s look at an example.

  • Assume that an individual has taxable W-2 income of $200,000, dividends of $40,000 per year, and intends to sell assets to finance part of the taxes that are due on the Roth IRA conversion in 2010.

  • Assume no preference items, apart from the long term capital gain when assets are sold, and that the taxpayer will take the standard deduction and two personal exemptions for himself and his spouse.

  • Assume that those asset sales will be $200,000 and he has the option of selling assets where he has a very low basis (thus maximizing his capital gains) or other assets where his basis is high relative to the sales price, yielding no gain.

  • If he sells the low basis assets (assume a basis of $20,000) his gain will be $180,000, and under the AMT calculations his Federal tax on that gain would be $33,300, or an effective rate of 18.5%. But that’s before we come to the conversion issue.

  • Now—with an IRA conversion of $1,000,000, his total income before the asset sale is not $240,000 for 2010, but $1,240,000. And that disproportionate amount of ordinary income to preference income will reduce the Federal tax rate on the latter back to the nominal 15% which would apply in the absence of the AMT. That saves even this taxpayer $6,300 per year in Federal taxes.

  • Finally, don’t forget about state taxes. What's most important here are your future plans. If you currently reside in a high income tax state but are planning to retire to a low or no income tax state such as Florida or Nevada, that will affect the ultimate outcome of this decision—or perhaps when you might decide to move.

So the lesson here we believe is obvious—before converting, for most taxpayers it’s well worth having your accountant run the numbers on the entirety of your tax situation both to illuminate the results for you personally and the proper course of action to optimize those results, i.e. to minimize your tax liability now and in future years based on the current tax code, not what may happen with tax rates in future years.

The Deferral Period

Obviously if only a few years remain before you will need to start withdrawing from your now converted IRA to sustain your consumption needs or wants, there is little benefit to converting. But it is equally obvious that if you have means from other sources to meet those needs, a key advantage of converting is that you can potentially extend the deferral period almost indefinitely.

While you have to leave the money in the converted IRA for a period of at least five years before withdrawing, it’s more important that the converted IRA will not be subject to minimum withdrawals beginning in the year the taxpayer attains age 70 ½. Thus, the deferral period can ride for as long as you wish, and potentially the full amount accumulated, including all future investment earnings, could be left to your heirs. That benefits them and not you, but certainly will be among the goals that many taxpayers will take into account in making this decision.

This factor also comes into play in another, potentially significant way. If a taxpayer has to make the minimum withdrawals starting at age 70 ½ even if he doesn’t need the money, the time horizon for his investments in the IRA inevitably shrink when compared with the potentially indefinite period that may be available under the Roth IRA. So it is likely that this will influence his choice of investments, as it should. The higher rates of return historically available in equities should be more appealing, and the greater volatility that choice entails less threatening, if the investments can ride for essentially an indefinite period of time before they are likely to be withdrawn.

The central point is this: the longer the deferral period that you anticipate after conversion, the more likely the outcome is that at the end of that period you will have more accumulated net worth than if you had not converted.

When Should I Convert?

In our view, the single most compelling reason to consider converting now is the opportunity for re-characterization. Congress’s beneficence in making re-characterization available is no doubt a reflection of the fact that our government is starved for revenue, and making these conversions as attractive as possible for 2010 was perceived—and we think accurately—as a way of boosting tax revenues for this year. In the absence of that perception, there can be little doubt that our legislators would not have seen fit both to remove the income limits that previously limited the availability of these conversions, and to give taxpayers more than one bite at this particular apple.

If you are contemplating conversion—or even if you’re not sure—you should convert as early as possible in 2010. That will maximize the amount of time you have to further contemplate your decision—was it right for you and your family?

In addition, it will yield the most information about whether you should re-characterize or not. The no-brainer situation is this: if your investments should decline substantially in value between now and the latest date you can re-characterize, you would definitely consider re-characterizing, i.e. undoing the conversion. It would be pointless to pay taxes at the higher amounts that would be required if the IRA you converted had declined significantly in value. That is particularly the case since you can re-convert within such a limited time after you have undone the previous conversion.

But even this point must be caveated. If you take the long view (which is the most important view with this issue) it may be in your interest not to re-characterize even if your investments decline in value in the short term. The wrinkle is that mentioned earlier—the prospect that marginal tax rates will increase at the beginning of 2011. So if you plan to reconvert after a re-characterization, the effect of the higher tax rates that will apply for such a reconversion in 2011 has to be measured against the decline in value of the Roth IRA in the previous year.

Take an example—let’s assume that:

  • The Roth IRA conversion at the beginning of 2010 had a value of $1,000,000, triggering Federal taxes of $350,000 at the 35.0% Federal rate.

  • At the end of 2010 the account has declined in value by 5%, to $950,000.

  • The taxpayer recharacterizes, eliminating the $350,000 in taxes and retaining $950,000 in the IRA.

  • He reconverts at the beginning of 2011.

Under this scenario, he will now owe taxes of $376,200 on the $950,000 conversion ($950,000 times the top Federal rate of 39.6%). Under either scenario he will have $950,000 invested in the converted IRA. But he will owe 7.5% more in Federal taxes even converting at the lower amount than he would have paid had he not re-characterized the 2010 conversion. So it is not at all clear that he’s better off by having re-characterized, if his losses have been modest and he’s still confident that in the long run the conversion will benefit him and his family.

The easier case is: what should you do at the end of the re-characterization period if the account has increased in value? The amount of that increase will almost certainly influence that decision (the more the better and the more likely it is to be in your interest to continue the converted account). And worst case, you will have the benefit of the maximum amount of current information at the end of the period, including the ability to take into account potential changes in our tax laws that the Congress may have seen fit to pass in the interim.

How Much Should I Convert?

Another element favorable to the taxpayer is that this doesn’t have to be an all or nothing decision. So in a sense you have the opportunity to diversify the tax risk, along with the investment risk you inevitably assume within the IRA. If you decide to convert half of the amounts available, for example, at least one of your two decisions will have been the definitively correct one, whether marginal tax rates have increased or decreased from now until the point that the money will be spent.

What Should I Convert?—or Should All My Eggs Be in One Basket?

There is another interesting wrinkle, that many taxpayers will find themselves wrestling with even if they did not make a conscious decision to convert into multiple Roth IRAs rather than a single Roth IRA. Many taxpayers have more than one IRA or the ability to create more than one since they will have accumulated funds in 401(k) plans from various employers over the years, and have never consolidated those funds within a single rollover IRA.

But even if you do not have that situation, you could create multiple Roth IRAs by converting some fraction of your current traditional IRA (or a rollover from a 401(k) or other defined contribution plan) into a Roth IRA, and then converting another (or several others) into additional Roth IRAs. By doing so and investing the various IRAs in different asset classes or at least in different investments, you will ratchet up the probability that at least some of those IRAs will have gains which will make re-characterization less necessary or attractive.

But we’d advise—don’t go crazy here. Sloth alone has left many taxpayers with multiple IRAs and other retirement plan accounts, and there’s a point beyond which the aggravation of keeping track and on top of those investments isn’t a reasonable use of your time.

Where Should I Get the Money to Pay the Taxes When Due?

While we have touched on this point, we should emphasize it further since it is central to the ultimate objective—a higher net worth for yourself or your heirs. To maximize the amount that is shielded from Required Minimum Distributions and thus is available to accumulate investment earnings over time, the better choice is to pay the taxes from outside the IRA, rather than cashing out a portion of the assets within the IRA to pay the taxes due. The taxpayer that has the most to gain from a Roth IRA conversion is the one who expects to defer the period before the funds will be spent the longest. That deferral is boosted when the amounts invested are not being depleted by Required Minimum Distributions, since those distributions would trigger immediate taxation and reduce the amount of invested funds remaining to accumulate earnings. Over time, the avoidance of the RMDs will be a significant contributing factor in an eventual outcome that creates a greater accumulation of wealth for the taxpayer and his heirs.

So What Should I Do?

It is rare that Congress has been inclined to provide such flexibility to taxpayers, particularly those with the means which make a decision potentially so material to their financial future. In fact we can think of no other instance where this has been the case. It is this flexibility and the opportunity to rethink and undo your decisions which we believe most supports a decision to convert as early as possible in 2010. Then, just relax as you consider further your options and emerging information through the end of 2010 before finalizing a decision to maintain the converted account or to undo the transaction.


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