Okay, I’ll try to eat right and exercise, but I still like biscuits and gravy. As a child, I was raised on the stuff, and I’m not giving up this breakfast for the world. It’s warm and filling, “hearty and nourishing,” as Mom would say.
What do biscuits and gravy have to do with Roth IRA conversions? Well, as a tax advisor I learned that clients always want to hear about ways to save taxes. And if we can’t save taxes, then let’s find ways to defer them as long as possible. So, the idea of a Roth IRA conversion and paying taxes now rather than later seems as alien as giving up biscuits and gravy.
That brings me to the biggest hurdle that may stop me from converting my traditional IRA to a Roth IRA. That is, the need to overcome the EMOTION associated with paying taxes before I have to. Paying taxes early goes against the grain. It creates a frown on my face. What am I, a fool? I’m hearing scraping fingernails on a chalkboard even before finishing this sentence.
Cutting to the Chase: More Details About Roth IRA Conversions
Let’s regress for a moment and review the basic principles of Roth IRA conversions. Beginning in 2010, any taxpayer can convert a traditional individual IRA into a Roth IRA. Roth IRAs have some significant advantages over traditional IRAs. Namely:
Given these benefits, every IRA should be a Roth IRA. However, converting a traditional IRA to a Roth IRA may not be a simple decision. For one, if you convert a traditional IRA, you will be required to pay income taxes on the value converted. It’s difficult for most of us to embrace this voluntarily. Therefore, it’s important to get some help from a trusted advisor if you’re considering a Roth IRA conversion.
Clients often ask if they have any options. Well, there are a few. For traditional IRA conversions in 2010, you’ll be allowed to pay the income taxes on the IRA value converted in 2011 and 2012. More precisely, one-half of the IRA value converted will be recognized as taxable income in 2011 and one-half in 2012. Alternatively, you may elect to have all the taxable income recognized in 2010.
Should You Take the Plunge?
A critical question would be, “What is your tax bracket in the year(s) of conversion?” Just as important, however, is your tax bracket in your retirement years.
There are many variables to consider when contemplating converting your traditional IRA to a Roth IRA. One’s tax bracket is the single most important economic variable.
Some other variables include:
Considering Cost Benefits
If you believe your tax bracket will be significantly lower during retirement, converting to a Roth IRA makes little sense. You’ll need to carefully consider your tax bracket in 2010, and contrast that to the tax brackets you expect for 2011 and 2012. Remember, unless you elect to recognize the value of the converted IRA as income in 2010, you’ll pay taxes on the conversion in 2011 and 2012, when tax brackets will most likely be higher than they are today. In fact, with current-day federal budget pressures, tax brackets will most likely be higher for the foreseeable future.
Another significant consideration is where you will get the money to pay income taxes on conversion. Ideally, you’ll want to use non-IRA funds. If you need to use IRA funds, you’ll likely diminish the advantages of the conversion. Economic models show that if tax rates and investment yields remain the same, it should not make a difference what funds you use. But to assume constant tax rates and investment yields is a dicey proposition in today’s environment. Also, it’s not normally desirable to sell assets which trigger capital gain taxes. If you have capital losses to offset the capital gains, good for you.
Some folks don’t need to take IRA distributions to live on during their retirement years; these folks are more ideal candidates for a Roth IRA conversion. Remember, there are no required minimum distributions with Roth IRAs, in which case, your Roth IRA will continue to grow tax free.
Considering Your Beneficiaries
A couple of final observations are in order before my anti-tax emotions take over again. Since I’ve been building a pretty good case for a Roth IRA conversion, it’s weakening my constitution and paying taxes early seems a little more palatable.
In reviewing the benefits of a Roth IRA conversion, also think about your beneficiaries. A surviving spouse who elects to treat a decedent’s Roth IRA as her own is also not required to take minimum distributions.
Non-spouse beneficiaries will be subject to the required minimum distribution rules, which will eventually deplete the Roth IRA. But, don’t lose sight of the potential years of tax-free investment returns being passed to your heirs.
According to Dennis Brach, BPM Shareholder, “What better way is there to pass wealth to your kids than a Roth IRA, particularly one that you converted?” If you can pay the income taxes on the Roth IRA conversion and your estate has sufficient resources to pay the estate taxes from non-Roth IRA funds, the Roth IRA will be inherited income tax-free by your kids.
Let’s close by discussing timing. Obviously, it’s better to entertain a Roth IRA conversion when the market value of your IRA is low. If you believe market values will increase in 2010, it would be more beneficial to consider a Roth IRA conversion early in 2010.
Additionally, it would be to your advantage to extend your 2010 income tax return as long as possible (that would be until October 15, 2011). You ask why? Well, there is an “undo” provision available, which would allow you to treat the conversion as though it never happened. The deadline for this ‘recharacterization’ is the due date of filing your tax return, including extensions. This would give you the most time possible to look at all the variables and determine whether you’ve made a prudent decision.
What Big Al Said
Remember what big Al said about income taxes:
“The hardest thing in the world to understand is the income tax.” Albert Einstein
Ultimately, whether or not to convert a traditional IRA to a Roth IRA is not a simple decision. The biggest hurdle that remains for me is paying the income taxes early. I don’t like it, never will like it, and the very thought stirs up my emotions. A helping of biscuits and gravy doesn’t seem so bad right now.
This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.