Roth conversion: the greatest tax break you don’t know you have
Posted September 2, 2009on:
Starting from tax year 2010, the Tax Reconciliation Act permits all taxpayers to make Roth IRA conversions, regardless of income level. Previously, taxpayers with a modified adjusted gross income of $100,000 (or more) were not permitted to make Roth IRA conversions.
With a stroke of the pen, many affluent Americans can increase their wealth by 10-20% in their lifetime. If circumstances are right, they may even double their wealth for their family.
Take John, for example. He is 50 years old and has a traditional IRA with a balance of half a million dollars. He is in the 35% tax bracket now. Assuming John investments grow at 5% regardless of which account holds them, let’s examine these four scenarios:
A: Both income tax and capital tax rates stay the same, at 35% and 15%, respectively.
B: Income tax rate stays the same, long-term capital gain tax rate increases to 20%.
C: Top income tax rate increases to 45%, long-term capital gain tax rate stays the same.
D: Top income tax and long-term capital tax rates increase to 45% and 20%, respectively.
Using a Roth conversion scenario analyzer I developed, I calculated the accumulative benefit of Roth IRA conversion when John reaches 85 years old. (See chart below)
What makes a Roth IRA more valuable than a traditional IRA?
With a traditional IRA, contributions are tax deductible and distributions are taxable. A Roth IRA is just the opposite, contributions are not tax deductible but qualified distributions are tax free. With income taxes expect to increase at least for the top bracket tax payers, it makes sense to pay tax now than in the future.
Unlike a traditional IRA, Roth IRA accounts are not subject to required minimum distribution (RMD). For wealthy Americans who do not need to live on their IRA distributions, mandatory RMD is like slowly stripping them of their tax breaks. This feature of a Roth IRA is mind-bogglingly valuable.
How to make the conversion?
In the case of John, he has to have $175k to pay taxes if he converts all at once. John may not have that much cash. (If he withdraws money from his IRA to pay taxes, he is subject to a 10% penalty.) In addition, the conversion is irreversible after Oct 15 following the conversion year. Therefore careful planning is required to maximize the conversion benefit. Contact me at 301-42-4220 or firstname.lastname@example.org if you need some help with your Roth IRA conversion.