The Roth Conversion Conundrum

10/5/2009 - Beaufort, SC


Next year all IRA owners will have the opportunity to convert their traditional IRAs to Roth IRAs. Prior to 2010, this conversion option was available only to those whose modified adjusted gross income (AGI) was under $100,000. This $100,000 limitation is eliminated in 2010 and all years thereafter.

In 2010 there will be a new class of Roth conversion candidates, those traditional IRA owners with AGIs of $100,000 and up. This group has been targeted by the financial services industry, and the conversion hype is building as 2010 approaches. If you Google "Roth conversion" you'll get almost two million hits. The advertising stuffers in my monthly bank and mutual fund statements are filled with colorful graphs, pie-charts, and photos of smiling, trendy couples at their laptops doing Roth conversion analyses.

To save you the trouble, I have just spent the weekend browsing the web and fiddling for hours and hours with the many Roth conversion financial calculators. My analysis was incomplete, unscientific, and flawed.

However, my conclusion is this: Roth conversions for those making more than $100,000 have limited appeal. There are too many variables and unknowns to justify the price for converting.

Background Roth IRAs started in 1998. Contributions to Roth IRAs are not deductible. The earnings are tax exempt. After five years, distributions are free of income tax and are not required to begin at age 70½. However, contributions to Roth IRAs are limited when AGI reaches about $160,000 for married taxpayers and about $105,000 for singles. Before 2010, traditional IRAs could be converted to Roth IRAs if the owner's modified AGI was under $100,000. The conversion is costly: income tax must be paid on the amount converted to the Roth IRA.

New Rules in 2010 As stated, the $100,000 income limitation for Roth conversions is eliminated for 2010 and thereafter. The price to convert remains the same. The amount converted must be reported as ordinary income. For conversions made in 2010, and 2010 only, the taxpayer can elect to report half of the income in 2011 and the second half 2012. These new rules affect Roth conversions only. The Roth contribution limitations remain unchanged.

The "Recharacterization" Option If you switch your regular IRA to a Roth IRA, you have the opportunity to undo it. You may "recharacterize" your newly converted Roth back to a traditional IRA, but you must do so by the time you file your tax return. For example, if you convert your regular IRA to a Roth in 2010, you may switch back to a traditional IRA before the filing due date for your 2010 tax return, plus extensions. In other words, you get a "do over" or a Mulligan on the conversion. You would consider recharacterizing a Roth IRA conversion, for example, if the value of the Roth IRA drops after the conversion.

The Calculators If you Google "Roth conversion calculator," you'll find many websites with calculators allowing you to play "what if" games for your analysis. Be wary of these "analyses," as they are based largely on your assumptions and guesses as to what you believe will happen in the future, all of which could be wrong. Nonetheless, it is time well spent, because you'll get a perspective of your choices.

I worked with several different calculators, changing assumptions on ages, future tax rates, investment return rates, and mortality. I was surprised by the results. The net after tax difference between converting to a Roth (and paying immediate taxes) or staying with a traditional IRA (and pay taxes on the distributions as they are made in the future), were not that much. In many cases, staying with the traditional IRA was the better choice. Where the Roth conversion was the "right" choice, it was not by much, and, in my view, not material enough to prepay huge income taxes.

When Conversions Might Work There are some circumstances when Roth conversions for high earners may be attractive.

•· The traditional IRA owner is young, and even with $100,000 AGI, is in a moderate tax bracket. This works, however, only if the owner can pay the tax on conversion with other funds. If IRA funds are used to pay taxes, there will be a 10% penalty on the premature distribution.

•· If the traditional IRA owner has expiring tax losses, it may be worthwhile to use them by increasing taxable income through a Roth conversion.

•· If the traditional IRA has taken big investment losses, but the owner expects a long term, big recovery, a conversion can be tempting. By converting the traditional IRA to a Roth, the owner is betting that the immediate income taxes he pays will be worth larger gains in the future. For example, traditional IRA investments are down from $100,000 to $60,000. If the owner is young, and expects the portfolio recover over many years, paying tax on $60,000 now may be a good bet to have a larger fund fully tax free in the distant future.

•· If the traditional IRA owner believes that income tax rates will be much higher in the future, converting and prepaying income taxes might be a bargain.

•· The traditional IRA owner is retired with very low income, or he owns a business from which he can control his income. If he can keep his outside income artificially low when the Roth conversion income is reported, he can pay taxes at a discount.

•· "Deathbed conversions" may be appropriate where estate taxes will be owed. The conversion to the Roth will reduce the potential federal taxable estate by paying large income taxes. The savings in estate taxes might exceed the amount paid in Roth conversion income taxes.

•· The traditional IRA owner may want to create a tax-free stretch IRA for children or grandchildren. Beneficiaries of Roth IRAs can spread distributions over their lifetimes. The earnings on the Roth IRA are tax free as well as the distributions. In a traditional IRA stretch, the beneficiaries must pay taxes on the distributions.

Conversion as a Crapshoot Even in the cases where the Roth conversion has appeal for an owner with income of $100,000 or more, the conversion is not compelling. In each of these "opportunities" described above, the IRA owner is rolling the dice based on many assumptions. I'll take my chances with a lottery ticket instead.

Conclusion Expect to be bombarded with Roth conversion hype over the coming year. If the IRA owner has income under $100,000, the conversion options have not changed much. The younger the IRA owner and the lower the owner's income, the better a conversion looks.

However, for the new class of Roth conversion candidates, those making more than $100,000, the conversion opportunity will not be attractive. "No-brainer" conversions will be rare.

Finally, for both classes of potential Roth converters, those with incomes over $100,000 and those with incomes below, the conversion is less attractive if the taxes must be paid from the IRA itself.

Eugene Parrs 2009