Roth IRA Conversions – Choose your own Adventure

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Roth Conversion crossroads

You’ve probably heard that 2010 is the year of the Roth IRA conversion. With the repeal of the $100,000 income ceiling for Roth IRA conversions and for the first time ever, anyone with any IRA type can convert it to a Roth IRA regardless of their tax filing status. Here’s the important part:

By converting your traditional IRA to a Roth IRA, you are agreeing to pay taxes now on previously untaxed money in exchange for the right to have that money grow indefinitely without further tax obligations.

The question of whether to convert or not is best answered by a comprehensive and personal analysis that includes both tax management and investment management advisers. Further, the decision is usually not as easy as a simple ‘yes’ or ‘no’. Additional factors may affect each investor’s decision, such as:

  • whether to convert the entire IRA or just a part
  • whether to convert today or later (depending on whether you want to pay the taxable amount at one time or over the next two years)
  • and so on

Similar to the choose-your-own-adventure books popular in the early 1980s, the question of whether and when to convert your traditional IRA is an adventure with a number of choices to be made.

When a Conversion Does Not Make Sense

We can make the initial choice of whether to convert a little easier for you by identifying the circumstances in which a conversion does not make sense, and those are:

  • If the IRA funds will be used within 10 years. Converting will not make sense in this situation because there is simply not enough time for the investment growth to compensate for the pre-paid taxes.
  • If the funds are not available to pay the taxes on the conversion. While half of the taxes due can be deferred as late as the filing of your 2012 return, those funds still have to be a available and if they are not, the conversion should not be completed. Taxes paid with money from the IRA will be treated as a distribution too, so unless you are in a position where you can withdraw from your IRA without penalty, then a 10% penalty will be assessed.
  • If the funds in the IRA will be donated to charity as part of your estate plan. Qualified charities can already liquidate the gifted IRA without paying taxes, and donating your IRA increases the value of your donation by your marginal tax rate. Of course, as of today, an IRA can only be donated after your death, not before.
  • If you are concerned about a market crash. If you’re confident the market will repeat the record-setting free fall of 2008, then you should delay your conversion until the market hits bottom. The primary reason is this: taxes are assessed on the value of your account on the day of the conversion. So, from a tax perspective, the lower your account value is on the date of conversion, the lower your assessed taxes.
  • If your are predicting lower taxes. If you project your tax obligations will be lower in the future than they are today, due to a lower tax bracket or other expected changes such as a post-retirement reduction in income, then a conversion now is not a logical choice.

If none of the situations above fit your circumstances, then a Roth conversion might be a valid option. Let’s break down some of the choices you’ll need to make.

How much of the traditional IRA will you need to use and when?

  • If you plan to use some of the traditional IRA funds now and the rest in the near future, then convert only the portion you don’t need for at least ten years. Assuming tax rates remain the same or
    higher, our cutoff for time required to justify prepayment of taxes is 10 years from the date of conversion. If you will need part, but not all, of your IRA funds within ten years then you might choose to convert only the portion you don’t need within your 10-year window.
  • If you plan to use the funds in your traditional IRA after ten years from now, then convert the entire IRA as soon as possible. Converted funds will grow indefinitely with no tax obligations upon withdrawal. If you’re concerned about increasing federal tax rates, then the converted funds will be dramatically more valuable than either the tax-qualified funds in an IRA or the non qualified funds where everything but the initial investment is still taxed.
  • If you do not plan to use or need the funds in your traditional IRA, then convert the entire IRA as soon as possible. If the funds in your IRA are eventually to be passed on to heirs, then converting now has three primary benefits:
    1. The converted funds are not subject to Required Minimum Distributions (RMDs) and will therefore continue to grow until your estate is executed at your death and the funds are distributed.
    2. Distributed funds will not have an associated tax burden upon receipt of the inheritance.
    3. Funds can continue to grow tax exempt, even after distribution to your heirs.

    If you’re planning to convert all or even a portion of the traditional IRA funds, when is it best to time the conversion?

    • If you believe a market recovery will continue on a fairly linear and upward trend, then you will want to convert as soon as possible. While the recovery in 2009 was impressive, the markets are still over 35% off the record highs of 2007. While no one forecasts an immediate return to 2007 levels, if you expect even minimal asset appreciation, then the sooner you convert the better because you will be assessed taxes based on the value of the traditional IRA on the date of conversion.
    • If you forecast impending market adjustments or corrections, then you will want to delay your conversion to as close to the market bottom as possible. Taxes will be assessed on the value of your traditional IRA account on the date of the conversion, so if you expect the future value of your account to decrease, then you will want to wait and convert it when the account value is lower.
    • If you’re planning to convert all or even a portion of the traditional IRA funds, when should you pay the taxes on the conversion?

  • If you are concerned that your marginal tax rate will increase from your 2010 levels in 2011 or 2012, then you should pay the entire tax due when filing your 2010 return. Your marginal tax rate can increase due to changes in the Federal tax code or with an increase in income and either or both can affect your tax bracket. If you’re worried about an increase in your taxes, then you will want to pay the taxes with your 2010 tax return to avoid the increased taxes on your converted funds.
  • If you are not concerned about increases in your marginal tax rate, or if you do not have the funds to pay the additional taxes with the filing of your 2011 return, then you should elect to pay the tax with the filing of your 2011 and 2012 tax returns. If you elect not to pay the tax with the filing of your 2010 taxes,
    you can report half of the converted amount of income on your 2011 tax return and the remaining half on your 2012 tax return. Taxes will still be asses on your marginal tax rate for the year in which you are reporting the income.

If you’re planning to convert all or even a portion of the traditional IRA funds, you’ll need to decide how to invest the converted funds.

  • If you are interested in long-term growth, and you are willing to accept “market” risk for all or part of the funds in your converted Roth IRA, then you should transfer all of your higher-risk investments into separate registration from your lower-risk positions. Converted Roth IRAs can be unconverted and the taxes that have been paid can be reclaimed. So, if the market was to have an unexpected contraction between the conversion and October 15, 2011, then the conversion could be re-characterized, the taxes could be reclaimed, and the IRA returned to its previous pre-conversion status. The key is the entire registration of the
    converted Roth has to be converted. Therefore, if the equity portion of a converted Roth is in one registration and the fixed income portion of a converted Roth is in a separate registration, and if circumstances warranted, the equity account could be re-characterized to save on taxes and leave the fixed income to grow without future tax obligations.

As we discussed in the beginning of this post, there are a host of questions that have to be carefully considered before choosing whether and when to convert. Your best bet is still to work closely with your tax management and investment advisers to ensure that you are first making the right decision about whether to convert or not, and second to make the right decisions

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