An in-depth look at the 2010 Roth IRA conversion opportunity

By tanderson22


Everyone, regardless of their income, can now convert a traditional IRA or pension plan to a Roth IRA.

Unless you've been in a cave for the last three months, you have no doubt heard of the unique opportunity to save that our government has given us for this year only. Everyone, regardless of their income, can now convert a traditional IRA or pension plan to a Roth IRA. Moreover, while there is still tax to be incurred (the amount of the conversion hits the first page of your 1040 as income earned), you have the option to defer the tax entirely in your 2010 tax year and to spread it equally over the tax years 2011 and 2012. In other words, Roths are on sale for 2010 -- buy now, pay later. But it gets even better, because you can change your mind until October 2011, if you decide conversion is not for you or your client and reconvert (re-characterize) to your IRA or their plan without tax or penalty.

Now that you know what the Roth conversion opportunity is all about, I am going to discuss some of the many considerations, rules, and strategies to consider whyen determining if conversion is right for you or some of your clients.

Let's start with the basics:

Who is most likely to benefit most from converting?

  • A young person, whose retirement is decades away, and who can afford to pay tax now in order to enjoy an easy retirement later. $10 a week or $40 a month with tax-free compounding at 8 percent for 30 years would yield $140,000 in retirement savings. If you were to save $200 per month, you'd end up with $1,050,000.

  • Someone who has a chance to hit a homerun on an investment, like someone forming a new business. Hockey-stick investments, accomplished tax-free and then compounded for life, can result in phenomenal amounts. I know of someone who invested just $1,800 in their own startup through a Roth IRA and in a little over 10 years has grown that to several hundreds of millions, all tax-free -- and they are still 20 years from normal retirement.

  • Someone who has no need for near-term liquidity or withdrawal from their retirement savings, and whose current retirement investments are substantially devalued as a result of the recent recession, but are expected to recover in the future. For example, people owning real estate in their IRA who have experienced devaluation due to the market conditions can convert at these lower values, paying less tax, and then allow them to recover tax-free in their Roth IRAs.

  • People who believe that tax rates will increase substantially in the future and that the combination of their tax bracket and tax rates will place a larger burden on them in the future than their tax impact from converting, are persons to consider converting.

  • Those who want to leave their retirement savings to their heirs. Once funds are converted to a Roth IRA, they will grow tax-free during your lifetime and yours heirs at your death (if named as your beneficiaries and your custodian handles stretch or inherited IRAs). Your heirs will also pay lower estate taxes (which go back into effect in 2011), because the Roth funds have already been taxed. Who is less likely to benefit from converting?
    • Someone who has to use funds from their IRAs to pay the tax for the amount converted. You will effectively be paying tax on some of your money taxed, as the money used for paying the tax will be taxable when withdrawn to pay the tax on the remaining amount that is converted.

    • Those who intend to leave their IRA to a charity. They will be incurring a tax from conversion that could be avoided if they left the money in their traditional IRA and then donated the money tax-free to the charity.

    • Those who think tax rates will decline or that their tax bracket will be much lower when they withdraw funds from their IRA at retirement.
    So, let's say you are a candidate for converting to a Roth IRA. What are some strategies you can use to make the most of a 2010 conversion?

    Depending on the mix of assets in your retirement portfolio, you may want to convert one or more IRAs or plans, or certain assets within theses accounts, into separate Roth IRAs. That's because you may need to reverse one or more conversions back to traditional IRAs (re-characterizations), and having more than one Roth IRA to choose from can allow you to choose the losing Roth [e.g., containing asset(s)] that may have depreciated since conversion) from those Roths and investments that are doing better than others. In doing so, your winners will continue to grow tax-free. You also avoid having to pay tax at a higher value at the time of conversion for an asset that later depreciates before the deadline for a re-characterization (up to October 15, 2011 which is your deadline with a tax foiling extension).

    Also, you should avoid combining converted amounts with Roths formed in prior years, because if you ever need to recharacterize, the calculations (which need to be prorated) can be complex and not necessarily to your advantage.

    Another strategy is to consider converting only a portion of your traditional IRA or pension plan, because you may have one or more depreciated assets that are likely to appreciate in the future. Converting the assets before they appreciate will save you on taxes that would apply if you were to convert them after they appreciated. Also, the overall tax burden may be too high for you if you convert all of your traditional IRA(s) in one year.

    Bear in mind that there is a five-year rule associated with Roth distributions following a conversion. Any distribution during the five-year period starting on January 1st of the year of your conversion, will be subject to a 10 percent penalty on the entire amount of the conversion (not distribution), unless the distribution is made after age 59.5 or another exception applies. Also, if the individual who spread out the income inclusion over 2011 and 2012 dies before 2012, the deferred amount is includable in the year of death, unless the spouse acquires the deferred amount. The moral to this story is don't die before 2012 if you want the maximum benefit of a conversion to a Roth IRA!

    How do you decide whether or not to convert?

    Let's discuss the primary planning issues that need to be considered when evaluating the effectiveness of making a conversion to a Roth IRA. The basic idea is determining whether the cost of paying tax now on the amount converted is going to be exceeded by the time you tap your subsequent Roth IRA, when it will be exceeded, and what the resulting yield is on your money after the tax on the conversion. This then needs to be contrasted with the effective after-tax yield on your money if you did not convert. Remember, if you don't convert from a traditional IRA or pension plan to a Roth IRA, you will be required to begin taking minimum distributions from them commencing no later than April 1 of the year following the year you turn 70.5.

    *Note: When you take the distribution in that following year, it is for the prior year, so that you also have to take a current year minimum distribution, as well.

    Let's say you convert in 2010, and you opt to pay the tax in 2010 (although, as previously discussed, you could choose to defer the tax liability to 2011 and 2012 -- split equally), and that you convert a $100,000 IRA, and that your effective Federal and State tax liability rate combined is 43 percent. That means that your total tax liability won't exceed $43,000. Let's also assume that you do not pay that tax with the money in your IRA, allowing the full $100,000 to flow into your Roth. Let's also assume that whatever you invest your Roth into and what you would have invested your traditional IRA into had you not converted was the same, resulting in the same yield (e.g., 10 percent annually). Now let's assume that you get this yield (10 percent per annum) for five years and that you turn 59.5 in that fifth year, when you are eligible to take the money out of the Roth tax-free. That means that you'd have $161,051 tax-free from your Roth IRA.

    On the other hand, if you do not convert, and assuming that your tax rate remains at 43 percent over five years and you reach 59.5 and then take a distribution from your traditional IRA, you would withdraw the same $161,051, and pay $69,251.93 in taxes, leaving you with $91,799.07. With the Roth example, assuming you converted having paid $43,000 on the $100,000 IRA at the time of conversion, later removing $161,051 tax-free, you would net ($161,051 minus $43,000) or $118,051 after-tax or $26,251.93 ($118,051 minus $91,799.07) more than had you not converted. Sounds pretty good.

    But remember that had you not converted, you would have had an extra $43,000 to invest for five years (the amount of tax you would have paid to convert). If you invested that for five years at 10 percent (interest or dividends), that would have resulted in $69,251.93 gross based on earnings of $26,251.93, taxed at $43 percent each year, yielding $14,963.60 after tax. If you subtract that from the after-tax difference between investing the Roth IRA and the traditional IRA over the same five years, the benefit of converting over not converting is $11,288.33 ($26,251.63 minus $14,963.60). This amount is basically the advantage of growing and compounding the after-tax converted amount tax-free over the five-year period.

    Of course, the example above is relatively simplistic; however, the variables affecting your decision-making are essentially the same, regardless of what set of assumptions you make for each variable:

    1) What is your current tax rate (that will apply to a current conversion? 2) What will you tax rate be each year, post conversion? 3) What will your tax-rate be when you withdraw from your retirement account? 4) How much will you earn with your retirement account or your otherwise taxable investments? 5) How long will it be before you withdrawal funds from either your Roth IRA (if you convert) or your IRA (if you don't)?

    By the way, the above example assumes that you do not use money from your retirement account to pay the tax due from conversion. If you did use retirement funds to pay the tax, conversion is not to your advantage, in this example.

    So that pretty much sums up the major factors to consider when deciding to convert or not to convert. There are, of course, other advantages to a Roth post-conversion, as you are not required to withdraw from a Roth while you're alive, as you are at 70.5 with a traditional IRA, furthering the benefits of tax-free compounding. In addition, your heirs can take tax-free minimum distributions over their expected lifetimes, unlike similar distributions from a traditional IRA, which would be taxable. Finally, there will be less estate tax (if applicable) associated with Roth IRAs in years where the tax applies, because Roth IRAs are after-tax vehicles. The income tax you pay on the conversion reduces the size of your taxable estate (which may reduce the estate tax) without reducing the value of what you leave to your heirs.

    One final item to mention is that there is a software program (and maybe there are others), that I came across that automates the calculations and reporting for the process to evaluate the merits of converting to a Roth IRA. They have both a personal and professional version (for advisors). This may be a good tool to making the analysis of a client's situation a fee-based service. The cost is $175. You can find it here. There is also a free calculator I found here that you might try. Good luck and safe investing.

    *For further information, or to contact this author, please leave a comment and your e-mail address in the forum below.