The Investment Scientist

Roth conversion: the greatest tax break you don’t know you have

Posted on: September 2, 2009

Roth-conversion-opportunityStarting 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)

[turn on image function to see this chart]

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 info1@mzcap.com if you need some help with your Roth IRA conversion.

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19 Responses to "Roth conversion: the greatest tax break you don’t know you have"

This is a scary post. It’s like you are writing with half the facts.
1.Help me understand how the capital gains rate factors in at all with a Roth conversion?
2.Under scenario A the Roth would equal the after-tax traditional IRA. So the arguement is you can better control tax rates with the traditional IRA, tax management.
3.What does everything look like if tax rates go down? Or if you live off less money?
4.Your chart gives you no basis for comparison between Roth and traditional. It just shows Roth values. What do they mean?
5.Roth conversions are reversible.
6.One of the biggest benefits of doing it in 2010 is that you are allowed to spread the tax payments over two years instead of one.

Evolution,

It would take another article to answer all your questions. Let me start from behind.

6. Not necessarily so, Roth conversion is most advantageous for tax payers in the top bracket. For them, regardless of whether they spread the tax payment over two years or do it at once, they are stuck in the highest tax bracket. Also, the tax rate for the highest bracket will very likely increase in 2011 (when the economy will have recovered sufficiently to withstand a tax hike.)

5. Imagine you are in 2011, you made the conversion in 2010, you’ve paid the tax. Now you change you mind and what to convert it back. Are you telling me IRS will happily refund all the taxes you paid?

4. The benefit of Roth conversion is resulting from comparing conversion and non-conversion. It’s like saying John is 10 inches taller than Jane. If I don’t do comparison, how do I know the benefit.

3. If tax rate goes down, it may not be beneficial to convert. Do you truly believe tax rate will go down for the top bracket tax payers?

2. You are totally wrong on that. Just to give you some idea when even under scenario A, Roth is better than traditional. There is a thing called RMD under traditional which a Roth account is not subject to. If you think of an IRA as a tax shelter, with Roth you can stay under the shelter for as long as you like; with traditional, you get pushed out as you get older. (And this is just one key difference. There are others as well.)

1. When you get pushed out of your tax shelter, you have to pay capital gain tax. That’s how it factors in.

6. Agree to disagree because I do think there can be a strong benefit for people spreading the tax over two years.

5. They are reversible within the same tax year. You can’t say
they aren’t reversible because they are. Just like I can’t say they are not. I think you got my point.

4.”comparing conversion and non-conversion” Where is that comparison taking place? Only conversions show on the graph. Or maybe I’m miss reading…are you saying the benefit is for scenario A is $256,137? Because if that’s what you are saying I would love to see your calculation because I don’t know that I trust them.

3. If you haven’t noticed I’m playing devil’s advocate. I do, however, think it is important to weigh both sides, positive and negative.

2. My point is that scenario A they should be equal value. Then the person’s situation would determine which is best.

1. Tax shelter? You are comparing a Roth, where you pay ordinary income tax before the money goes in, to a traditional where you pay ordinary income tax when the money comes out. No capital gains involved.

Evolution,

First of all, thank you for playing devil’s advocate, it is helpful for readers to see dissenting views as well. Allow me to respond to your response point by point.

6. For people in lower tax brackets, the risk of tax hike is low. For them, there are indeed some benefit to spread the tax over two years. However, Roth conversion is most advantageous for people in the top tax bracket, and the article was written with them in mind.

5. I have to give it to you on this point; one can reverse a conversion by 10/15/2011. After this deadline, it is irreversible. I usually write my article within one page, and I have to be selective about what details to include.

4. That would take another five pages. For the reason in 5), I omitted the details. The purpose of the article is not to explain everything. The purpose is to alert readers about this opportunity. Afterward, they can do their own research or they can consult me. I can write a thorough, rigorous PhD dissertation about this subject. If nobody read it, it serves no useful purpose.

3. Good job playing devil advocate. 😉

2. Even in scenario A, they are not equal. Let say you have a $100k traditional IRA, you are in 35% bracket. If you convert to Roth, it would cost you $35k to pay income taxes. So you have two options: 1) convert and have $100k in a Roth IRA; 2) not convert and have $100k in a traditional IRA and $35k in a taxable account. With option 1, you will have no more tax for as long as you live; with option 2; even if the tax rate remains at 35%, you still get less after tax comparing to option 1. You do the math yourself.

1. With a Roth conversion, you pay your tax once, then the money in the Roth account will not subject to any taxation again, capital gain or income, for as long as you live. If your wife inherits it, she does not need to pay any taxes for as long as she lives as well. Bot you and your wife (spousal beneficiary) are not subject to RMD (Required Minimum Distribution), only your children (non spousal beneficiaries) who inherits this account are subject to RMD over their life time. There they don’t need to pay any income taxes either. That’s why I called it a tax shelter.

One big issue that I have with all of these types of Roth conversion analyses is that they never take into account the progressive tax system. That is, even if you are in the 35% tax bracket, you do not pay 35% tax on all your income. So saying that in retirement that all of your traditional IRA monies will be taxed at 35% is not correct. In fact, the only way this would be the case is if an individual had other income and investments in retirement such that they would be in the 35% bracket without the IRA withdrawals. I would argue there are very very few individuals who meet this criterion. It would be much more useful to use the effective tax rate assuming some reasonable level of other income and the standard deduction. I think you would find the Roth much less appealing in such a case.

For instance, my wife and I are in the 25% tax bracket but thanks to deductions and exemptions we pay only about 6-7% effective federal tax ($6500 total tax bill on about $100K AGI). So if we made a Roth conversion now, and our taxes were similar in retirement, we would be paying 25% tax to avoid paying 6-7% tax later.

Dave,

Thank you for the thoughtful comment. Here is what I see it.

Here we are looking at the incremental incomes of our decision, therefore marginal tax rate should apply, not the effective tax rate.

With your situation, there is a risk of Roth conversion; you may get bumped up to the 35% tax bracket in the year you convert if you do it all in one year. In that case, it does not make sense to pay 35% now for the privilege of not paying 25% in the future. However, if you can manage your conversion over a number of years without “upgrading” your tax bracket, it may still worth doing it.

Oh boy. Serious discussion here, hehe. 🙂

To me, aside from the fact that Roths aren’t subject to RMDs, it comes down entirely to tax rates.

Commutative property of multiplication tells us that a 25% tax hit now vs later doesn’t matter.

So the question is simply: Do you expect a higher tax rate now, or later? If an investor’s current IRA value is low enough that he/she can convert it (or part of it) without being bumped into a higher tax bracket, it can make a whole lot of sense.

On the other hand, converting an entire IRA with a large balance (albeit smaller than last year) can be a very poor idea if it ends up putting the investor in a higher tax bracket than he anticipates during retirement.

Mike,

I couldn’t have summed up better than you did.

Michael

The problem is, even assuming the tax laws stay the same, your tax rate in retirement is heavily dependent on how much of your income is coming from tax-deferred accounts (traditional IRAs and 401ks) vs after tax vs Roth accounts. Take the extreme example of a high-income individual (35% tax bracket) who retires with 100% of his savings in Roth accounts (due to converting in 2010). If his only taxable income is social security, he will likely be in the 10% bracket. In that case, converting to a Roth was a terrible deal for him, even if he is able to keep the conversions taxed at 35%.

So the problem is not nearly as straightforward as your post would imply. In my opinion for most people it is not desirable to convert Roth funds at any tax rate higher than 15%. There may be a very small fraction who could benefit from a small partial conversion, so that their tax rate is minimized over their lifetime.

Dave,

I agree with you that each person is different, and Roth conversion is not a one-size-fit-all solution.

That said, that point of my article is that Roth conversion can be tremendously valuable to top bracket tax payers. Take the person in my example, without Roth conversion, his RMD could easily put him in the top bracket even if he does not need the money and would rather the money stay his IRA.

You say “his RMD could easily put him in the top bracket”. For someone age 70, RMD is approximately 1/26 of the account balance.

The top tax bracket starts at taxable income of $372950 for 2009.

For an RMD to put someone in the top bracket, they would need more than $9.3 million in their IRA/401k! How many people are really in this situation?

And even if the RMD did put him at $372950 taxable, he would still not be paying 35% on the whole amount. In fact, dollars 1-372950 would be taxed at approximately 27% effectively. So comparing a 35% conversion tax rate to a 35% withdrawal tax rate is not a fair comparison.

Dave,

Many top bracket tax payers, at least those I am dealing with, have other sources of incomes as well. The RMDs from their IRAs usually are not their main sources of incomes. They usually do not need to live on RMDs.

My analysis applies to the next bracket tax payers as well whose marginal tax rate is only 2% behind the top bracket.

However, you made a good point here. In the situation that their RMDs are their only sources of incomes and they need to live on those incomes, then Roth conversions may not make sense for them.

The main idea behind the conversion is that people that were not able to contribute into a Roth IRA can now convert deferred IRA money in to the Roth.

The LARGEST reason by far is having another bucket to choose from when taking distributions. You can coordinate all of your sources of income (Trad IRA, Roth IRA, SS, Pension, ordinary income, etc.) to take the most advantage of the tax code…whatever that may look like in the next 10, 20, 30 years!

If someone does not have a Roth, it is best to convert up to (but not over into) the next tax bracket. This will at least move some of their money into the more advantageous Roth.

Someone wrote: “Commutative property of multiplication tells us that a 25% tax hit now vs later doesn’t matter.” Not quite right I think.

Suppose you invest 1K$ in a traditional IRA and I invest 1K$ in a Roth IRA and taxes are 25% always. I pay an extra $250 in taxes now and you invest a corresponding $250 in an extra investment account to cover the taxes on your traditional IRA when you withdraw from it years from now. All investments pay the same rate. You would be correct to say that “now v. later” doesn’t matter if you could avoid paying taxes on the income form your extra account. The problem is that you will be paying taxes on the extra account as it grows. So the Roth account is better even in this case.

Michael,

Now, I’m confused. I have been considering the accuracy of your post at Morningside Advisor entitled: “Roth Conversion’s Valuable Option” dated 10/26/09. In your post, you write, “According to the tax law, if one converts on Jan. 1, 2010, he gets until Oct. 15, 2011, to change his mind and reverse” (and convert back). Then here in your blog, you say in your response #4 to EvolutionOfWealth on 09/03/09: “5. I have to give it to you on this point; one can reverse a conversion by 10/15/2010”. Now back to your post at Morningside Advisor on 10/26/09, you say the reverse of a conversion can take place by Oct. 15, 2011. So I hope you can see why we are all confused. What is the real date that one can reverse a conversion; Oct. 15, 2010, or Oct. 15, 2011? This date can make a real difference in the planning we suggest for a client. Hmmm, maybe I should just go read the “tax law” you write about in your post before making a suggestion to a client that can affect their tax planning, right?

10/15/2011 is the deadline. Check the following link for detail

http://www.rothira.com/reverse.htm

A lot of confusion going on : ) If you are thinking of converting it is apparent that many factors will drive the should i or shouldn’t i. From my humble analysis the main two drivers to consider will be defined by the long term goals of the money. If wealth transfer is part of your planning strategy then long term tax free growth and no forced distributions become powerful allies. Even more of an argument for the conversion would be if you are using non q savings to cover the taxes. This can play out advantageously for several reasons A) people tend to have a longer term more aggressive portfolio outlook with retirement money, it is likely one would achieve greater long term returns in their IRA then the money in non retirement account + that money moved to a ROTH is no longer subject to OI and LTCG. It makes NO sense to convert a traditional if you are using the traditional IRA’s assets to pay the tax bill and do not have wealth transfer as a primary goal. The wealth transfer argument also plays out if you are in a lower tax bracket then the intended receiver, could be useful estate planning tool in that one could lower their overall estate value by taking the tax hit for the generation allowing them to continue tax free (Only applies to non spouse benni unless not filing joint)

These are all very good points John. Since Michael Zhuang has clarified that a client who converts from a traditional IRA on January 1, 2010 has until October 15, 2011 to reverse the conversion, it makes for a much more interesting scenario. The facts are: The client is a single female, with no spouse or children, but does have a valid stated will with non-relative heirs: has $ 500,000 in a traditional IRA; is 69 years of age; will be 70 yrs of age by June 16, 2010; has available funds in a non-retirement account to pay the taxes due for the conversion; has more than sufficient income to support herself from investments; and will receive a financial windfall in November 2011. Her desire is to use the advantage of conversion to pay the federal taxes now (there will be no state taxes in Florida where she is a resident), rather than paying higher income taxes and capital gains taxes over the life of the RMD. In other words, the client will never need to touch the IRA during her lifetime if she converts to a Roth IRA. The entire Roth IRA will be left to her heirs that succeed her. If she converts on January 2, 2010, if Michael is right, she can reconsider and reverse the conversion before October 15, 2011. This could really be a “heads she wins, tails she gets to play again” as Michael suggested in Morningstar Advisor, right? Especially if she can convert, and spread the tax payments out from January 2, 2010, thru 2011, and 2012. Interesting case. All thoughts and comments appreciated.

John,

Very good point you made here. Also, conversion will result in lower estate taxes since the money one uses to pay taxes now not be subject to estate tax when one dies.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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