Roth IRA Conversion: Now May be the Time

January 15, 2009

By Dave Polstra, CPA, CFP®, CIMA® 

Do you have an IRA? Has it gone down in value? Do you think income tax rates will increase in the future? If you answered “yes” to all three, then you may want to consider converting part or all of your existing IRA to a Roth IRA. For 2009, your Adjusted Gross Income must be under $100,000 to do a Roth Conversion, but beginning in 2010, the income limitation goes away. In other words, anyone will be eligible to convert their existing IRAs to Roths beginning in 2010. Furthermore, for folks who convert in 2010, the income taxes attributable to the conversion can be spread over the following two tax years, i.e., 2011 and 2012.

What's the Point of a Roth IRA?
The main difference is when you pay income taxes on the money you put into the plans. With a traditional IRA, you pay the taxes on the back end — that is, when you withdraw the money during retirement. With a Roth IRA, it’s the exact opposite. You pay the taxes on the front end, but there are no taxes on the back end. Therein lies the beauty of the Roth — once money is in the plan, its growth and future withdrawals are tax-free. Upon conversion to a Roth, any untaxed income inside the traditional IRA becomes taxable.

So, for someone with $500,000 in an IRA (assuming no non-deductible contributions) who decides to convert to a Roth, they must report that $500,000 as ordinary income in the year they convert. From then on, the Roth will grow tax-free.

Who is a Roth Conversion Best Suited For?
Industry experts suggest an ideal candidate would be someone who:

1. Has “outside funds” (e.g. taxable brokerage account liquid assets) to pay the income tax on the conversion,
2. Will not need the Roth IRA to meet his/her annual living expenses,
3. Desires to leave a tax-free asset to children or grandchildren, and
4. Expects to be in the same or higher tax bracket in future tax years.

In this situation, the Roth IRA is viewed more as a wealth transfer tool rather than a retirement income vehicle. And, since Roth IRA owners don’t have to take minimum distributions, more money is allowed to grow tax-free during the owner’s lifetime. In addition, while Roth IRA beneficiaries must take minimum distributions when the original Roth IRA owner dies, these distributions are generally tax-free. So, the Roth IRA is an ideal retirement asset for which to transfer the largest amount of wealth to future generations.

For example, Mark, age 69 and single, is considering converting $100,000 to a Roth IRA. At the present time, Mark is in the 25-percent tax bracket and expects to be in the 25-percent tax bracket for the foreseeable future. In addition, Mark has named his son, John (age 42), as beneficiary of his traditional IRA.

Based on certain assumptions, John would have over $150,000 more assets in 30 years if Mark were to convert $100,000 to a Roth IRA in 2009. This is shown in Figure 1.

Figure 1

(This example and chart appear with permission of CCH, a Wolters Kluwer business, and were originally published in Family Tax Planning Forum by Robert S. Keebler and Stephen J. Bigge, TAXES - The Tax Magazine, October, 2008, www.tax.cchgroup.com. Assumptions include: Mark’s age at death 86; taxable outside investment account @25,000; yield 2%; growth 7%; ordinary income tax rate 25%; capital gains tax rate 15%)

What's the Downside of Converting to a Roth IRA?
Assuming you can look past paying taxes upfront upon conversion, the biggest downside of converting is the risk that our current system of income taxation gets overhauled (i.e. some sort of national sales tax replaces the income tax) in such a way that traditional IRAs are no longer taxable upon withdrawal. It seems unlikely in our current environment that deferred retirement assets would escape taxation under any new system (especially as applied to wealthy families). If that happens, then those who converted to Roths may have paid unnecessary taxes. If you are considering a Roth conversion, make sure to seek appropriate counsel from your CPA to be certain of the rules and applicability to your particular situation before making a final decision.