Year End Tax Planning - Roth IRA Conversion

High on the list of tax planning issues for 2010 is whether to convert money in a traditional IRA to a ROTH IRA. The Internet offers articles and calculators to help investor-taxpayers understand that the law has changed, and that there is an opportunity, but an opportunity that comes at a cost.

Our national debt is thirteen trillion dollars, our deficit over a trillion a year, so our government hopes you think conversion makes sense. If you convert all or part of a traditional IRA to a ROTH, the amount is taxed as ordinary income. In prior years, taxpayers with more than $100,000 of modified adjusted gross income were ineligible to convert. This year, anyone can convert, and pay the tax half in 2011 and half in 2012. Using an election, you may pay the tax in 2010.

The lure of the ROTH is powerful. Distributions are (generally) never taxed. There are no required minimum distributions until after death.

The main argument against conversion is that income tax is due, at ordinary rates. People hate writing checks to Uncle Sam, especially checks they do not have to write. Traditional tax planning is to defer tax as long as possible.

Another argument against conversion is that tax rules may change. ROTH earnings may never be directly taxed, but they could be pulled into the calculation to determine if social security is taxable, or made subject to the surtax to fund health care.

Current income tax rates expire at the end of 2010. Taxpayers in the highest tax bracket will pay more, 35% instead of 39.6%. Higher future tax rates are an argument for current conversion.

The only answer to the conversion question is "it depends". Personal circumstances, net worth, cash needs, tax brackets, investment earnings, and investment strategy all play into the decision. There are conversion calculators available on the Internet. A web search on "ROTH IRA calculators" will allow you to test your own numbers. Depending on your tax rate now, tax rate later, investment earnings rate now, and investment earnings rate later; conversion may or may not make sense.

The first principle to grasp is that taxes due on conversion should be paid from funds outside the IRA. If you have to withdraw IRA funds to pay the tax on conversion, then conversion probably doesn't make sense. The entire conversion amount is taxable, but only the money left after taxes goes into the Roth. Worse yet, a 10% penalty may be owed on the tax portion of the withdrawal, if a person is not 59 1/2.

Suppose a hypothetical sixty five year old taxpayer has funds in a money market earning 1%. He has $1,000,000 in an IRA, earning 4% on $900,000 invested conservatively, and 8% on $100,000 invested more aggressively. His tax bracket is 25%.

The taxpayer is considering conversion of $100,000 to a ROTH, and intends to make his more aggressive (8%) investments within the ROTH. After conversion he has a $100,000 ROTH earning 8%, and a $900,000 traditional IRA earning 4%. Without conversion, he has the $1,000,000, divided into two segments, $100,000 earning 8%, and $900,000 earning 4%. Twenty five thousand of cash is used to pay tax on conversion, but retained without conversion. Required minimum distributions begin in five years, and are transferred from the $900,000 traditional IRA to the money market. Taxes on the RMD's are paid from the money market.

If the taxpayer does not convert, at the end of ten years, he has more net worth, but with conversion he has more "after tax" money.

The taxpayer paid $25,000 to convert. He also gave up money market earnings on that $25,000. He saved taxes on required minimum distributions, which were higher based on a traditional IRA balance of $1,000,000 as opposed to $900,000. He earned more within the traditional portion of the IRA, with conversion, because required minimum distributions were lower.

Overall, the taxpayer comes out ahead an estimated $27,000 for having converted, after ten years, using assumptions weighted in favor of conversion. The conversion tax is paid out of money earning only 1%. The portion of the IRA that is converted ($100,000) is assumed to earn the highest yield of 8%.

There is no law that says you cannot manage your funds to your best advantage. The taxpayer chose a conservative, blended strategy. He used low yielding cash to pay current taxes. He converted only 10% of his IRA. He recognized that the more investment success he achieved within the ROTH, the more conversion made sense.

Suppose another hypothetical taxpayer, age 80, keeps most of his net worth in cash and CD's. He has $100,000 in an IRA. His tax bracket is 35% in 2010, but will be 39.6% in 2011. If he converts the $100,000, he depletes his cash by $35,000, and loses the earnings on that cash. If he converts, he will avoid taxes at 39.6% on required minimum distributions. He will save about $6,000 on taxes after ten years, assuming a constant yield on all funds. If he can achieve a higher yield within the ROTH, he will save more.

Suppose a young adult with $10,000 in an IRA converts to a ROTH and pays $1,500 in tax. Assuming a 4% yield on all cash and investments, and a tax rate of 15%, the taxpayer gains nothing by converting. Constant tax rates and constant investment returns yield no advantage to conversion.

Older, wealthier taxpayers with cash, tierred investments, and higher tax brackets should look at conversion. Investment performance within the ROTH is crucial to achieving the highest savings. If the money that is paid in tax up front would have earned more than the ROTH will earn, then conversion is the wrong choice.

People interested in a ROTH should look beyond the conversion decision, beyond any projection figures. ROTHs will provide tax and investment planning opportunities in the future. In a "down" income year, a person with earned income might make a ROTH  contribution instead of a traditional IRA contribution. A retiree enjoying a high income year may take distributions from a ROTH versus a traditional IRA, to avoid reaching a higher tax bracket.

Suppose you identify a stock that you think has potential. You want to own the stock in a ROTH, so that anticipated appreciation is never taxed. You convert $20,000 from a traditional IRA to a ROTH, and buy the stock. If it doubles, you have $40,000 in the ROTH, and you will avoid paying tax on the gain. You will owe tax on $20,000. If the stock drops to $10,000, you have the option of re-characterizing (returning the ROTH funds to the traditional IRA) before October 15, 2011, and paying no tax.

There are variants to this strategy. You convert IRA funds to several, separate ROTH IRA accounts, and before October 15, 2011, you determine which accounts did the best. Those you leave as a ROTH, and the others you re-characterize.

Caution! There is a five year rule governing distributions from ROTH IRA's and a special five year rule related to distributions from converted ROTH IRA's. Do not attempt any conversion technique without consulting your tax professional.

Tax and investment professionals should work together. Your CPA should prepare tax projections, and your investment advisor should advise how investments should be positioned. We encourage you to apply these ideas to your situation.