Roth IRA Conversions

Summary: To
convert or not to convert, that is the question. Many websites, and even some
advisers use simplistic calculators, that don’t do the decision justice. Others
use modeling so sophisticated they could be mistaken for space shuttle
algorithms. While some advisers bring nearly religious zeal to their views, the
realities are that for some taxpayers the answer is obvious, for some a coin
toss (not as cool as the slick models, but perhaps as effective of an analysis
for many). We’ll try to demystify the issue with some background. Then we’ll
try to help you identify whether you seem to be pretty obviously in the convert or not convert camp. For those in the gray zone in between
we’ll try to give you some pointers to discuss with your advisers.  In the end the Solomon-like approach of
splitting the baby might just be the most prudent approach for the gray zone.

What’s the Deal?

Roth IRA’s are cool: ◙ All growth is tax-exempt. ◙ There are no
minimum distributions required at age 70½ as exist for regular IRAs. That’s big
since the assets can continue to compound tax free which enhances the Roth
asset growth prospects (hopefully enough to cover the tax paid and then some)
and possibly creditor protected. ◙ If your
modified adjusted gross income (MAGI) exceeds $100,000 you cannot convert your
regular IRA to a Roth but in 2010 that limit disappears. ◙ If you convert in 2010 the income tax due can be spread out over two
years. You can elect out of this deferral and pay all the income tax in 2010 if
that proves advantageous (e.g., large rise in future tax rates). Election has to
be made by 10/15/11, on an extended return. Hedge your bets and extend.

Favoring Conversion

For conversion to make sense
some of the following should be present: ◙ Future tax
rates are higher than the rate you pay now when you convert. This creates a
positive tax arbitrage. Rising rates seem like a Wilt the Stilt slam dunk…how
could they not? ◙ You have significant tax
attributes are available to offset the current income tax triggered (e.g,
charitable contribution carryovers, investment credit carry-forwards, “Madoff-type”
carryovers). ◙ Post-conversion Roth IRA
funds will almost assuredly not be needed to support living costs for a long
time if ever, so that the assets can remain invested to compound tax free to be
bequeathed to your heirs. This is a key question which requires an analysis of
your cash flow, assets and “burn-rate” (spending). If you’ll bequeath your Roth
to a properly designed generation skipping tax (GST) exempt trust you
grandchildren may be able to withdraw Roth IRA money over their life
expectancies. That’s lots of years of income tax free growing.   ◙ Adequate cash
resources outside of IRA plans are available to pay the income tax due on
conversion.

Asset Protection

Asset protection worries
might make conversion a great deal if your post-conversion Roth will be
protected under state creditor protection laws from claimants. Conversion could
present an opportunity to convert a regular IRA to a Roth IRA, and using
outside funds to pay the tax, you have effectively taken 60-cent dollars that
are protected inside a regular IRA, and turned them into 100-cent dollars that
are protected inside the resulting Roth IRA, and eliminated a non-protected
asset by using it to pay the income tax on conversion. You can also continue
making contributions to your Roth IRA after age 70½ and never have to withdraw
from it. That leaves Roth dollars snug and safe. In contrast you cannot
contribute to a regular IRA after 70 ½ and you have to take out minimum
required distributions (MRDs) each year.  

Other Factors

To get it right many
variables need to be factored into your analysis. ◙ What will your post-conversion investment rate of return be? ◙ Is there a tax bracket arbitrage available? For example, if you’re
terminally ill it might pay to convert while married filing joint at a lower
tax rate than your surviving spouse will have if she takes distributions out of
a taxable IRA at a single person’s tax bracket after your death. Arbitrage can
be negative if converting pushes you from a current low bracket into a higher
tax bracket. ◙ Will the government
directly or indirectly taxing Roth dollars (e.g., via phase outs of other tax
benefits based on Roth balances or withdrawals, etc.)? If the federal fisc
remains hungry in decades to come most anything might be possible. ◙ What financial needs for health or other emergencies might cause Roth
funds to be tapped before anticipated? ◙ Can you
really model these factors? How can you guesstimate how the government may
change the tax rules applicable to well to do taxpayers, yet alone guesstimate
the percentage likelihood of such changes?. ◙ If you
convert the tax you pay will be removed from your estate possibly lowering your
estate tax. ◙ If you split the baby and
only convert say ½ your IRA, perhaps you should first split the IRA into parts,
say a bond part and equity part. Then convert the equity part only which has
more likelihood of appreciation then the bond part.

Estate Tax and 691(c)

What’s the estate tax
consequence of Roth versus not? Some background first. ◙ Your IRA is included in your taxable estate and could be subject it to
a 45% estate tax. ◙ Since a regular IRA
represents income that has not been subjected to income tax (ignoring
non-deductible contributions), this is called “income in respect of a decedent”
(IRD). IRD is subject to income tax as your heirs receive it. So the 55% left
after the estate tax bite gets bitten again with a 35% income tax rate (which
will likely increase in the future).
Ouch! ◙ The double tax whammy is
mitigated by an income tax deduction for the federal estate tax paid. Code Sec.
691(c). This is not a perfect offset. ◙ If you’re in
a state that has an estate tax there is no offset for state estate taxes paid. ◙ The beneficiary paying the tax might not be the one inheriting the IRA
and getting the benefit. ◙ The IRD deduction may be
subject to phase out of deductions under Code Section 68 reducing the benefit.
So, it might be a better deal to die Roth’d.

How to Convert

◙ If conversion still seems
plausible after the initial evaluation review timing of tax payments with your
CPA. You can pay all at once or spread the payments. ◙ Consider whether you can
divide your IRA into separate IRAs by asset class and
convert each asset class IRA separately. That way, if a particular asset class
IRA declines in value before the extended due date for the return, you can
un-convert (recharacterize) it and avoid the tax.  So if you convert 1/1/10 right after the ball
drops in Times Square, you can hold  your tax breath until 10/15/11 to decide.
That’s a 21 ½ month looky looky. Why pay income tax to convert a looser? Be
wary that the IRS and/or Congress may get hip to this jig and try to kibosh it.
They’re trying to do just that with zeroed out short term GRATs that similarly
present a “head you wins, tails try again” paradigm. If you un-convert you have
to wait 30 days before trying again. ◙ Review estimated tax payment requirements with
your CPA.

Qualified Plans

If your child is your qualified retirement plan beneficiary
she can direct your plan directly from the qualified retirement plan to either
a: (1)Roth IRA; or (2)Non-spousal
beneficiary regular IRA rollover IRA. However, once the qualified plan has been
rolled into a regular IRA it cannot thereafter be converted to a Roth IRA.
Caution – if you rolled an ERISA plan into a regular IRA and now Roth it some
experts worry this might taint the protection you had under the Bankruptcy
Protection Act.