In the scheme of your retirement, estate and financial planning, converting your traditional IRA that is subject to income tax at the time of distribution to a Roth IRA, from which distributions are income tax free, may be one of the more challenging exercises that you undertake. However, making the right decision now may create a cash benefit in the future for you and your beneficiaries in the tens or hundreds of thousands of dollars. The Tax Increase Prevention and Reconciliation Act (enacted in 2006) removes the $100,000 income limit for converting funds in a traditional IRA to a Roth IRA beginning after 2009. This creates a planning opportunity for many people who are not currently eligible to convert traditional IRAs. It also creates opportunities for individuals who have rolled or who may roll retirement plan benefits to IRAs and those who may be eligible for in-service distributions from employer sponsored retirement plans.

          After refreshing your IRA understanding, this article discusses the conversion conundrum and then provides clues for you to follow to resolve your particular conversion conundrum.

          BACKGROUND.  The traditional IRA is funded with tax deductible contributions and the withdrawals are taxed to the owner/beneficiary as ordinary income. With limited exceptions, withdrawals prior to age 59½ are subject to a 10% penalty and distributions must commence no later than the owner attaining age 70½.  Those not eligible to make deductible contributions because of participation in an employer sponsored retirement plan and income in excess of certain limits may make nondeductible contributions. Withdrawals of the earnings are taxable income.

          The Roth IRA is funded with after‑tax contributions. After you attain age 59½ and the Roth IRA has been open for 5 years, withdrawals of all amounts are income tax and penalty free. In addition, there is no requirement that you commence distribution at age 70½.

          THE CONUNDRUM: whether to convert the traditional IRA to a Roth IRA? This decision requires that you consider many unknown factors such as the tax rates that will be in effect at the time you commence distribution, how long you will survive after you begin withdrawal, and whether you intend to use your IRA to benefit next generation beneficiaries. Most significantly, the opportunity to convert comes at the cost of paying income tax on the amount converted at the time of conversion. This is the actual and philosophical obstacle that is the greatest challenge in the conversion conundrum.  Paying tax earlier than is required flies in the face of the fundamental tax principle of deferral. 

          Conventional wisdom would say that you should defer taxes on your IRA investment until retirement, which is a time when most people are in a lower income tax bracket. To maximize the conversion benefit, non-IRA funds should be used to pay the tax due on the amount converted. Although this is a painful feature of the conundrum, for those under age 59½ this avoids the penalty that would apply to the IRA funds used to pay the tax and by using non-IRA funds to pay the tax, the entire IRA balance compounds tax free after the conversion.

          In order to evaluate a possible Roth IRA conversion, you should take the following factors into consideration:

          1.     Age at conversion and estimated age at retirement (or default to age 70½ because the traditional IRA is subject to the lifetime minimum distribution rules);

          2.     Estimated rate of return on investments;

          3.     Income tax rate at the time of conversion and the estimated income tax rate at the time of withdrawal; and

          4.     The duration over which you expect your IRA to provide benefits to you and perhaps your children (who, because of your hard work and sacrifice, will earn more than you and be in a higher tax bracket at the time of distribution to them).

          At the time of conversion you will know your age and your current marginal income tax bracket.  We cannot prognosticate what will happen to income tax rates 5, 10 or 20 years from now. We do know that the marginal tax rates are scheduled to increase in 2011.  This prompts planning now for conversion in 2010.  Following is a table of income tax rate changes scheduled to take effect in 2011:

          Will you really “retire” at age 65 or will you change careers, become a consultant or transition to a reduced work schedule?  Will your spouse continue to work even after you retire?  Although you may believe that your non-IRA investments will only be taxed at 15% for dividends and capital gain, do not underestimate the income tax impact of required minimum distributions from a traditional IRA and/or pension or profit sharing plan. Beginning in 2011, the marginal income tax rate for single taxpayers with current income between $31,850 and $77,100 and married taxpayers filing jointly with income between $63,700 and $128,500 increases to 28%.  Part time or continued employment plus taxable required minimum distributions could keep your taxable income in a higher tax bracket than you may expect.

          Faced with many unknowns and contradiction of conventional wisdom, how should you proceed to determine whether conversion from a traditional to a Roth IRA may be advantageous to you and your beneficiaries?  

CLUES.  Following are some clues to help you resolve your Roth conversion conundrum.

1.     Calculators.

          “Roth Conversion Calculator” inserted in the internet search engine of your choice will yield many online tools to assist you.  The nearby conversion calculation table demonstrates the effect of conversion under certain assumptions.  To use the table, find your current age and current tax rate and estimated tax rate during the time that you will take distributions.  For example, consider the 50 year old currently taxed at 35% who expects his/her marginal tax rate to drop to 28% in retirement. The table uses $100,000 so that for comparison purposes you can easily convert your own IRA as a percentage of the table. For example, if your IRA balance is $25,000, then your results will be 25% of the values in the table. The table assumes that distribution would commence at the required beginning date at age 70½ and assumes an average annual return on investment of 8%.  The table above assumes that the entire value of the traditional IRA is taxable and the $35,000 (35% x 100,000) tax to be paid at the time of conversion will be paid from non-IRA assets.  The manner in which the advantage (or disadvantage) has been calculated for each respective age and tax bracket in the table is demonstrated below using this 50‑year old IRA owner. 
 

          Be careful not to make the conversion decision a purely mathematical exercise.  If there is a real likelihood that you will need the IRA funds within five years of conversion, you will lose the benefit of tax free treatment of the earnings, so conversion of this portion of your traditional IRA may not be wise.

          If your actual and projected tax rates are not reflected in the table, use the closest rates as a guide. For example, if you are age 50 and currently in the 33% bracket and expect to be in 28% bracket, look at the 35/28% results. Because the initial tax paid at conversion will be less, the conversion benefit will be slightly greater because the tax paid at conversion will be less.  If your age is between the 5‑year brackets in the table, look to the next older age.  If it is advantageous for someone older and in your tax bracket to convert, then it will be advantageous for you. 

2.     Distribution Duration.

          For purposes of the table, the comparison is shown at the commencement of distribution.  However, it is unlikely that anyone would withdraw the entire balance at age 70½.  Going back to our example of the 50-year old at the 35/28% marginal brackets, consider the following example demonstrating the benefit of withdrawing the $466,096 in substantially equal payments of $40,636 over 20 years (assuming average 6% earnings).  Because the Roth IRA does not require minimum lifetime distributions, there is an opportunity to create an even greater benefit for next generation beneficiaries.  See clue number 5 below.
 

3.         Consider Other Retirement Assets.

          If you participate in other employer sponsored retirement plans that will pay a taxable benefit during retirement, this benefit, combined with your traditional IRA distributions, may push you into a higher tax bracket in retirement.  With the exception of those near retirement, the table generally indicates a Roth advantage for those whose income tax rates do not drop significantly in retirement.

4.         Tax Opportunities.

          If circumstances are such that you can avoid taxes at the time of conversion because of operating losses or other tax losses, you avoid the issue of paying taxes now or then.  If your tax on conversion is zero, then you can accomplish the conversion without the current tax cost.  This is why Roth IRAs are so beneficial to student workers.  In most cases, they can fund their Roth IRA with the income from part-time jobs and because they pay little or no income tax, the student worker pays no tax to fund the Roth and they will pay no tax in the future on the compounded return.

5.         Estate Planning.

          Avoiding required lifetime minimum distributions during the owner’s life gives you the opportunity to hold assets in the Roth IRA, compounding tax free, while you exhaust other taxable income producing assets during your lifetime.  If you need the Roth IRA assets then they are available but there is no required distribution during your lifetime. At your death, if your children are in a high tax bracket, the tax free Roth distributions would be a tremendous benefit to them.  In this case, the “disadvantage” shown in the conversion calculator table may not exist.  For example, consider the 60‑year old in the 35/28% now and then tax brackets.  At age 70½, the Roth IRA is valued at $179,085.  If this owner survives 15 years to age 85, does not withdraw assets from the Roth IRA and earns an average 6% return, the Roth value will be $429,187.  If the child beneficiary is age 55 at the time of the owner’s death and the child takes only the required minimum distributions, compare the following results:

          This conversion calculation does not "reinvest" the pre‑tax $162,134 required minimum distributions during the owner's lifetime and it does not attempt to determine the impact of estate taxes.  However, it is clear that the longer the time for tax free compounding, the greater the Roth advantage for the next generation beneficiary. 

6.         Hedge.

          Too much information?  Too many unknown variables?  Hedge.  There is no requirement that you convert an entire IRA and no limit on the number of conversions. If your annual income does not exceed $100,000, you do not need to wait until 2010 to make a conversion. You can make partial conversions as your circumstances permit to meet your planning objectives. Consider mixing and matching your assets between traditional pre-tax and some Roth IRA assets.  This approach may take the sting out of the income tax payment at conversion by spreading the tax over multiple conversions.  But, as noted above, income tax rates are scheduled to increase in 2011 so spreading conversions into years after 2010 will be more costly.

CONCLUSION

          Do not avoid the conversion conundrum because it appears difficult. Defaulting to no action may penalize both you and your beneficiaries. The Roth conversion conundrum is not resolved solely by mathematical formula.  Calculators will help you, but they should only be one tool that you use in making the decision. If your annual income exceeds $100,000, you have time before 2010 to take pencil to paper and apply the clues set forth above.  Now is the time to sit down with your financial and estate planning advisors to determine the best solution to your conversion conundrum.

Conversion Calculation Table