Conversion AversionSubmitted by Financial Planning Hawaii on May 13th, 2014
Strategies for the conversion of traditional IRAs into Roth IRAs are a popular topic in the financial and tax planning communities. Count me in the minority camp that believes conversions are overhyped as a planning concept.
To refresh, a Roth IRA conversion involves a distribution of funds from a traditional tax-deferred IRA (or employer qualified retirement account (e.g., 401(k)) into a Roth IRA. The conversion distributions from the traditional IRA are taxed in the year the distribution is made at the IRA holder’s marginal income tax rate, but are not subject to early withdrawal penalties, even if the IRA holder is under age 59 1/2. Subsequent withdrawals from the Roth Conversion IRA, including appreciation on the conversion amount over time, are generally distributed income tax-free (assuming the conversion IRA has been in place at least five years and the account holder is over age 59 ½) to both the account holder and, eventually, to his/her beneficiaries.
On the surface, the appeal of the Roth conversion is obvious – potentially decades of tax free growth with no required minimum distributions after age 70 and a wonderful tax free gift to beneficiaries upon death. Where I take issue, however, is with the notion that such conversions are advisable for everyone. Particularly puzzling to me is why the 2010 tax law change that eliminated the income limits on conversions has led to a surge in the popularity of Roth Conversions. Why would higher earning IRA holders choose to convert during their peak earning years (i.e., when their marginal tax brackets are highest)? Has it ever occurred to the pro-conversion crowd that a primary motivation for the tax law change was to increase tax revenue?
In addition to the afore-referenced plain vanilla Roth conversions, another strategy that has been making the rounds with advisors lately (two FPH clients have queried me on the idea in the past few months) is the so-called “back-door” Roth conversion. This strategy is apparently being touted by some financial advisors as a tool for helping people whose incomes are above the limits* that would permit them to make a regular $5,000 ($5,600 if age 50+ in 2014) annual Roth IRA contributions. Under this scheme, higher-earning folks are being advised to make a non-deductible (i.e., after-tax) $5,000 contribution to a traditional IRA for each spouse and then immediately convert to Roth IRAs, thereby circumventing the income limits. Although this may seem like a clever approach, the catch is that, for people who may have other traditional IRA accounts, the IRS considers the total of all your IRA accounts when determining the amount of tax owed when you convert to a ROTH. For example if your $5,000 non-deductible IRA represents just 5% of y our total IRA holdings, you will still be required to pay tax on 95% of the conversion proceeds.
The bottom line is that investors need to be careful about playing too fast and loose with complex IRS rules pertaining to retirement accounts. This is a point I made in my previous blog post entitled “Don’t Mess with the IRS”. The old “look before you leap” adage certainly applies to Roth IRA Conversions as well.
So under what circumstances might Roth Conversions merit strong consideration?
➢ Young people with low to modest incomes. Since most people begin their careers at the lower end of the corporate pay scale, converting traditional IRAs ,Rollover IRAs, and/or former employer retirement plans to a Roth IRA may be an excellent idea, as decades of tax free growth may be an excellent foundation for a financially secure and income tax free retirement. [Note: folks in this demographic segment may also do well to make annual Roth IRA contributions, or, if available, to make after-tax contributions to the Roth 401(k) portion of an employer’s retirement plan.
➢ Retirees who are in lower marginal tax brackets. To the extent that conversion distributions may be taxed a low marginal federal income tax brackets, the tax impact of the conversion (and the breakeven time thereafter) may be significantly lower than if the conversion had been made during ones peak earning years.
➢ High income investors who may have considerable money in qualified retirement accounts (e.g., 401(k)s, but no money in traditional or Rollover IRAs. For these folks, the backdoor Roth conversion may be a viable option.
This list is by no means all-inclusive as there may be other circumstances where conversions may be beneficial as well. It should also be noted that, for some IRA holders, it may make sense to convert just a portion of one’s traditional IRA each year (i.e., just enough to keep the marginal income tax rate applied to the distribution low). Obviously, careful planning should go into all Roth conversion decisions and such decisions should probably not be made without first running the idea and the numbers by your CPA or tax advisor.
For more on this subject, see the following articles:
• Roth IRA conversions spike sharply – The Wall Street Journal
• Warning About Roth IRA Conversions: Often Misunderstood IRS Rule Can Cost You Money and Aggravation - Forbes
• Using Non Deductible IRAs to Get Money Into a ROTH – About.com
• The other way to invest in a Roth IRA – CNNMoney
• Income Limits for Roth Contributions in 2014 – Kiplinger’s
* The 2014 IRS limits for annual Roth IRA contribution eligibility are $191,000 MAGI for married couples filing jointly, $129,000 MAGI for single filers. As noted, there is no income restriction on conversions of traditional IRAs to Roth IRAs.
The information contained in this post is general in nature. Neither Financial Planning Hawaii nor J.W. Cole provides client-specific tax or legal advice. All readers should consult with their tax and/or legal advisors for such guidance in advance of making investment or financial planning decisions with tax or legal implications.