INTRODUCTION

Ever since the concept of tax-free Roth IRAs was introduced in 1997 as part of the Taxpayer Relief Act of 1997[i], Roth IRAs have been viewed as an attractive option for retirement and estate planning.[ii] 

Nonetheless, prior to 2010, many individuals were unable to make the conversion from traditional IRAs to Roth IRAs because they did not meet the income limitation, which prohibited individuals with a modified adjusted gross income in excess of $100,000 from converting their traditional IRAs to a Roth IRA.[iii] In addition, taxpayers whose filing status is married filing separate have been precluded from this conversion.[iv] However, under the Tax Increase Prevention and Reconciliation Act of 2005[v] (Act), beginning January 1, 2010, such limitations have been eliminated indefinitely, permitting all taxpayers, regardless of income or filing status, to make the conversion.[vi] Further, for conversions made in 2010, a unique rule under the Act permits the deferral of taxable income resulting from the conversion to be spread over three tax years. No taxable income is recognized in 2010; however, 50 percent of the taxable income is recognized in 2011 and the remaining 50 percent of the taxable income is recognized in 2012.[vii] 

Not surprisingly, there has been an abundance of publicity on Roth IRA conversions in 2010. This leads one to ask: Is conversion right for everyone? To attempt to answer this question, this paper will dissect the complexities of the Roth IRA conversion. Part I will compare traditional IRAs to Roth IRAs with respect to the tax effects of earnings, contributions, and distributions. Part II will attempt to determine who should make the conversion by examining the considerations for conversion. Finally, for individuals who do decide to make the conversion, Part III will provide the strategies for making the conversion. 

PART I. COMPARISON OF THE TRADITIONAL IRA AND THE ROTH IRA

There are two basic types of IRAs – the traditional IRA and the Roth IRA. In general, as provided by I.R.C. §408A, except as otherwise provided by the Code, the traditional IRA provisions continue to apply to the Roth IRA. Thus, for the most part, Roth IRAs resemble traditional IRAs. Nonetheless, there are a few important differences regarding earnings, contributions and distributions to note, as discussed below. 

Earnings in a Traditional IRA vs. Earnings in a Roth IRA

In general, earnings in a traditional IRA are tax-deferred, but not tax-free upon withdrawal. In addition, earnings are includible in gross income upon withdrawal and may even be subject to penalties if such withdrawals are made early (prior to age 59½).

For Roth IRAs, earnings are not only tax-deferred, but are also tax-free provided certain requirements are met upon withdrawal.   A withdrawal from a Roth IRA is nontaxable if it is a qualified distribution or to the extent it is a return of the owner’s contributions to the Roth IRA, which makes the Roth IRA particularly attractive to taxpayers subject to high marginal tax rates.[viii] 

In addition, traditional IRAs are subject to mandatory distributions beginning at the age of 70½. As a result, earnings in traditional IRAs are limited and are not allowed continued growth for the duration of the owner’s life. 

For Roth IRAs, on the other hand, there are no required minimum distributions at any age during the Roth owner’s life.[ix] Thus, Roth IRA owners who do not need the Roth IRA funds for support during retirement can maximize earnings and tax-free growth by retaining the funds within the account. Upon the Roth owner’s death, the required minimum distributions of Traditional IRAs are applied to Roth IRAs; however, the tax-free nature of a Roth IRA distribution is retained.[x] Nonetheless, Roth IRAs permit tax-free appreciation for potentially longer durations. 

Contributions to a Traditional IRA vs. Contributions to a Roth IRA

In general, traditional IRAs and Roth IRAs differ on deductibility, age requirements and contribution phase-out limits.

For traditional IRAs, contributions are generally deductible in the year of contribution in the amount equal to the lesser of the contributions to the traditional IRA or the general limit on annual contribution amount, which depends on the individual’s income, filing status, whether the individual is covered by a retirement plan at work, and whether the individual received social security benefits.[xi] In addition, contributions to a traditional IRA can no longer be made in the taxable year beginning the year in which the individual attains the age of 70½.[xii] Further, contributions to a traditional IRA are limited, for 2010, to $5,000 or $6,000 if the individual is 50 years old or older by the end of the year.[xiii] However, there is no upper limit on how much the individual can earn and still contribute.

Unlike contributions to traditional IRAs, contributions to Roth IRAs are never deductible.[xiv] Also, contributions to a Roth IRA are not subject to an age limit.[xv] In fact, contributions to a Roth IRA may be made at any age.[xvi] Further, while contributions to a Roth IRA is limited, as in traditional IRAs, for 2010, to $5,000 or $6,000 if the individual is 50 years old or older by the end of the year, the amount that an individual can contribute to a Roth IRA may be further limited depending on the individual’s income, filing status, and whether the individual has contributed to another IRA.[xvii] The maximum contribution limit (determined without regard to any reduction for traditional IRA contributions made) is phased out between certain levels of modified adjusted gross income (AGI).[xviii] For example, for the tax year 2010, individuals who have a modified AGI of $120,000 or more are prohibited from making an annual contribution to a Roth IRA.[xix] For married taxpayer filing jointly, the phase-out begins at $177,000.[xx]  In other words, contributions to Roth IRAs are subject to the same contribution limits applicable to traditional IRAs, but are, in addition, subject to modified AGI phase-outs which further limit the available contribution amount to a Roth IRA. 

Distributions from a Traditional IRA vs. Distributions from a Roth IRA

Distributions from traditional IRAs and Roth IRAs generally differ in the required timing of distributions as well as their taxability. 

For example, for traditional IRAs, an account owner must begin receiving required minimum distributions by April 1 of the year following the year in which the account owner reaches age 70 ½.[xxi] If distributions from a traditional IRA are not made or if the distributions are not sufficient in amount as is required, there may be assessed a 50% excise tax on the amount not so distributed. For Roth IRAs, on the other hand, there are no required minimum distributions at any age during the life of the account owner. However, if the Roth IRA owner dies, the minimum distribution rules that apply to traditional IRAs are applied to Roth IRAs.[xxii]   

Further, except to the extent of rollovers[xxiii], qualified charitable distributions[xxiv], tax-free withdrawal of contributions, and the return of nondeductible contributions, distributions from a traditional IRA are includible in gross income in the year of receipt. In contrast, distributions from a Roth IRA are not includible in gross income as long as such distribution is a qualified distribution, to the extent the Roth distribution is a return of the owner’s contributions to the Roth IRA, or to the extent the Roth distribution is from a Roth IRA that had been rolled over tax-free from another Roth IRA.[xxv] 

Part II. Who should make the conversion? -- Considerations for Conversion 

There is no simple answer as to whether a particular individual should convert a traditional IRA to a Roth IRA. There are many interwoven factors to consider prior to a conversion. If individuals convert, they will accelerate taxable income into an earlier year[xxvi], which contradicts the age-old cardinal rule of deferring taxes. Unlike a traditional IRA, a Roth IRA enables both tax-free withdrawals and avoidance of required minimum distributions, which allows wealth to grow tax-free for a longer period of time. To break through the uncertainty of this trade-off and provide a framework for weighing the advantages and the disadvantages of conversion, this part will address the core tax, financial and estate planning considerations for conversion.  

Tax Considerations

A conversion from a traditional IRA to a Roth IRA makes more sense when it does not create a lot of tax. This raises a very interesting planning issue because it is unclear at this point what the tax rates will be beyond 2010. Unless new legislation is enacted, the tax brackets above 15% will revert to their pre-2001 levels.[xxvii] This means the highest rate will rise from the current 35% to 39.6%.[xxviii] Under such circumstances, it may be beneficial for the individual to pay the tax earlier but at a lower rate. In addition, for individuals not in the highest bracket, the conversion amount, when added to gross income, could put the individual into a higher tax bracket. This is not the case if the individual has large business losses, net operating losses, or large itemized deductions to offset the increased income resulting from the conversion.[xxix] In addition, for individuals with current IRAs that are at a lower value due to stock market losses, a lower value would result in lower taxes upon conversion (because tax on conversion will be based upon the value of the IRA at the time of the conversion), and the recovery of the account would be tax-free under the Roth IRA. Further, while stock market gains are generally taxed at the preferential capital gains rates, stock market gains that are distributed from a traditional IRA are taxed at ordinary rates. This is not a concern with Roth IRAs because Roth IRA distributions are generally tax-free. 

A conversion from a traditional IRA to a Roth IRA also makes more sense when it avoids or reduces taxes. For individuals who plan to withdraw funds from an IRA before age 59½ and who would be subject to the 10 percent penalty tax for early withdrawals from the traditional IRA, a conversion to a Roth IRA may avoid the penalty since the Roth IRA is not subject to the penalty, provided distributions are made only after the five-year waiting period after the conversion.[xxx] Nonetheless, if the 10 percent penalty can otherwise be avoided, for example, by taking the IRA distributions as a series of substantially equally payments[xxxi], converting to a Roth IRA may not be necessary to avoid the 10 percent penalty and may unnecessarily accelerate income and impose a five-year waiting period before distributions can be made.   

Financial Considerations

Since a conversion from a traditional IRA to a Roth IRA is a taxable event, it generally only makes sense for individuals who have available cash outside of their IRAs to pay the tax. While individuals who do not have the available cash to pay the tax may sell assets to raise cash, such sale often triggers another taxable event.[xxxii] Similarly, borrowing funds to pay the tax will result in interest expenses that are generally nondeductible personal interest expense, with very limited exceptions. [xxxiii] Further, using funds from the traditional IRA to pay the tax on a conversion can be exceedingly expensive because the funds are subject to both income tax and, if the individual is under age 59½, the 10 percent early distribution tax.[xxxiv] Even more, doing so reduces the value of the IRA, which minimizes future potential for tax-free growth.

In addition, if the individual incurs a tax on the conversion, the conversion is beneficial if the eventual tax savings in the future (when the funds are withdrawn) are greater than the taxes paid today. In order to assess whether tax savings outweigh taxes paid, an individual must make assumptions about when the funds will be withdrawn from the IRA and the marginal tax rate upon future withdrawals. With the benefit of having more assets compound on a tax-free basis without the eventual drag of required minimum distributions, the longer the individual plans to wait before withdrawing the funds from a Roth IRA, the more likely the future tax savings of the Roth IRA will outweigh the tax on conversion. Likewise, if withdrawals on the traditional IRA will be taxed at a lower rate than the rate at which tax paid is on the conversion, paying the tax to make the conversion to a Roth IRA may not be advantageous. 

 Furthermore, the conversion makes more sense if it results in more overall wealth. Earnings in a traditional IRA are tax-deferred, but not tax-free upon withdrawal and earnings in a Roth IRA are not only tax-deferred, but are also tax-free provided certain requirements are met upon withdrawal. While permanently avoiding tax is generally better than merely deferring it, whether the value of deferring tax on the amounts transferred to the IRA plus the after-tax return on the current tax savings related to the traditional IRA contributions exceed the permanent tax savings on the Roth IRA’s earnings depends on several variables, including the individual’s current and future tax rates, expected earnings of the IRA, and time horizon before withdrawal. For example, if an individual (age 45, in the 15% tax bracket, with an existing traditional IRA valued at $50,000 and consisting wholly of deductible contributions and earnings therefrom) plans to make annual contributions of $2,000 to the IRA, the effect, in present value terms (assuming annual returns on the IRA of 10% and an AFR of 5%), of maintaining the traditional IRA and converting to a Roth IRA would be[xxxv]:

            If as above, however, the individual is in the 35% tax bracket in 2010, but expects to be in the 15% at age 65, the results would be[xxxvi]:

Further, if as above (tax rate of 35%), however, the individual is age 55 rather than age 45, the results would be[xxxvii]:

As the above examples indicate, whether conversion will increase or decrease an individual’s overall wealth ultimately depends on a variety of factors, each of which can independently affect an individual’s decision to convert or not to convert.   

Estate Planning Considerations

Many individuals are concerned about the impact of a conversion on their estate taxes. First, because qualified withdrawals from a Roth IRA are tax-free, converting a traditional IRA to a Roth IRA means that beneficiaries will receive the Roth IRA distributions free of income tax, which is not the case for a traditional IRA. Second, because there are no required minimum distributions from a Roth IRA, converting to a Roth IRA means that the individual will not need to take future required minimum distributions, which maximizes the amount that can grow tax-free and the amount that can be transferred to beneficiaries. Third, converting to a Roth IRA reduces the size of an individual’s taxable estate by the amount of tax dollars paid for the conversion, thereby reducing estate taxes to the extent retirement assets are subject to estate taxes.[xxxviii] In effect, the IRA owner is paying income tax that would otherwise be paid by his beneficiaries without actually making a taxable gift to them. 

While conversion does have its benefits, a federal income tax deduction is available for those who choose not to convert that may offset some of the benefits of converting.[xxxix] In particular, any federal estate tax paid as a result of owning a traditional IRA will result in an income tax deduction, the “income in respect of decedent” (IRD) deduction, for the beneficiaries of the traditional IRA.[xl] The IRD deduction has the potential to nullify the apparent estate tax benefit of the Roth IRA conversion and may put the alternatives of converting and not converting at near equal basis from a federal estate tax standpoint. It is generally where the IRD deduction does not fully compensate the traditional IRA holder for the payment of estate taxes (i.e., where beneficiaries cannot fully utilize the IRD deduction) is there a resulting estate tax savings with the Roth IRA conversion. Nonetheless, it is important to note that what really matters is not minimizing estate taxes, but rather maximizing value net of estate taxes.   

PART IV. STRATEGIES FOR CONVERSION

For taxpayers who do decide to make the conversion from a traditional IRA to a Roth IRA, this part will discuss the general strategies for conversion to avoid the 20 percent statutory withholding on rollover amounts, to minimize the effects of increased taxable income resulting from conversion, and to minimize investment risks.

Avoiding the 20% Withholding\

As discussed above, an individual may convert all or part of a traditional IRA to a Roth IRA by a direct rollover to a Roth IRA or by rolling over the amount received within 60 days.[xli] The disadvantage of a 60-day rollover is that the distributing plan must withhold 20% of the eligible rollover distribution for federal income tax purposes.[xlii] Thus, where possible, it is likely more advantageous to implement a direct rollover from a traditional IRA to a Roth IRA. 

Minimizing Effects of Increased Taxable Income Resulting from Conversion

As discussed earlier, conversion from a traditional IRA to a Roth IRA triggers taxable income to the extent provided by Section 408A(d)(3)(A)(iii). This increase in taxable income may have adverse tax effects on the taxability of Social Security benefits[xliii], the itemized deduction scaleback, education credits and other AGI-sensitive items[xliv]. Further, the increase in taxable income may push the individual into a higher income tax bracket.

To minimize the effect of increased taxable income resulting from a conversion, an individual can convert the balance of a traditional IRA into smaller components over several years to reduce the tax burden. [xlv] Of course, amounts postponed to years other than 2010 will not be eligible for the special two-year installment reporting that is available only to conversions in 2010. Nonetheless, by converting in series of smaller amounts, the conversion is less likely to push the individual into uncharacteristically high tax brackets and the tax on conversion will be smaller and easier for the average individual to manage.[xlvi]

Minimizing Investment Risk: Reconversion and the Roth IRA Conversion Segregation Strategy[xlvii]

An individual faces investment risks that could nullify the benefits of a Roth IRA conversion. For example, if an individual converts a traditional IRA to a Roth IRA that subsequently declines in value, the individual must, nonetheless, pay tax on the conversion on the (higher) value at the time of the conversion even though that value no longer exists. Fortunately, the Internal Revenue Code permits an individual to recharacterize the transaction by transferring the amount converted (and any related earnings attributable to the contribution) back to a traditional IRA no later than the due date (including extensions) of the individual’s federal income tax return for the year the conversion occurred.[xlviii] In particular, if the IRA’s value declines after it is converted to a Roth, reconverting the Roth IRA to a traditional IRA will prevent the individual from having to pay tax on a conversion based on a value that no longer exists.[xlix] For example, if a traditional IRA valued at $100,000 is converted to a Roth IRA and the Roth IRA account subsequently declines to $75,000 in value before the taxes on the conversion are due, the individual may undo the conversion by reconverting the assets back to the traditional IRA and avoid paying taxes on the $100,00. The individual can then wait three months and convert all over again. On the flip side, if the Roth IRA appreciates to $125,000, the individual can keep the Roth IRA and pay taxes on only $100,000.

Where IRA accounts may be funded with both depreciating and appreciating assets, the objective toward the end of the reconversion period is to reconvert only the losers. However, individuals cannot reconvert a portion of a Roth conversion by “cherry picking” only those assets that decline in value.[l] To counter the effect of this restriction, an individual may segregate different investments in the traditional IRA into separate Roth IRAs, that is, convert a traditional IRA into several Roth IRA accounts.[li] This will permit the individual to reconvert only those Roth IRA accounts that have declined in value, while maintaining those Roth IRA accounts that have increased in value. For example, assume that an individual has $100,000 of equities and $100,000 of bond income in his traditional IRA at the time of conversion. By the end of the year, the equities have declined in value to $50,000 and the bonds have increased in value to $150,000. The individual then decides to recharacterized an amount to allow him to pull out the equities. Had the individual converted the entire traditional IRA to a single Roth IRA, the individual must include in gross income for conversion $133,333, that is, the $200,000 value at conversion less the $66,667 reconverted amount ($50,000 securities value/ $150,000 bond value x $200,000 value at conversion), which prorates the gains and losses in the Roth account.[lii] On the other hand, had the individual converted the traditional IRA to two separate Roth IRAs, one for the equities and one for the bonds, the result is dramatically improved. The individual could reconvert only the Roth IRA with the equities. By doing so, the individual must include in gross income for conversion only $100,000 (the $100,000 value of the bonds on the date of conversion).[liii]  Thus, in employing this conversion strategy, an individual can use the benefit of hindsight by “cherry picking” the losers and avoid paying tax on asset values that no longer exist.

CONCLUSION

The floodgates have been opened for Roth conversions as an opportunity for individuals to reassess their retirement plans and an opportunity to more effectively manage their assets for retirement income and planning purposes. For most taxpayers, however, the right choice will not be obvious. Presenting the general rules for Roth IRAs, a comparison between Roth IRAs and traditional IRAs, the considerations for conversions, and the strategies thereto, this paper indicates that conversion is not right for everyone. Nonetheless, determining who it is right for is a difficult question to answer and requires complex analysis of individual’s circumstances on a case by case basis.