In conjunction with this article, Tigran Unciano, CFA, and member of the Pinnacle Peak Chamber of Commerce, will be hosting a seminar explaining these factors.  Please visit http://www.pinnaclepeakchamber.com/events/details/29-understanding-roth-ira-conversions for more details on attending this free seminar.

A Roth IRA conversion is a way for individuals to turn their regular or “Traditional” IRAs into a Roth IRA.  Individuals pay ordinary income tax on the value of the money converted, known as the “Roth Conversion Tax.”  Once converted, money inside a Roth IRA is allowed to grow without paying income taxes or capital gains taxes just like in a Traditional IRa.  The two most striking differences between a Roth IRA and Traditional IRA are:

Many individuals logically think that converting to a Roth IRA will shield them from paying income taxes and leave them with more disposable income.  They also believe that converting to a Roth IRA will result in larger account values since Roth IRA are free from required distributions, meaning money can be kept in Roth and grow tax-free for longer time periods.

The truth is that completing a Roth IRA conversion will not necessarily result in more disposable income or larger account values.  There are several, very important factors working simultaneously that affect the outcome of a Roth IRA conversion.  They are 1) an individual’s current and future marginal tax bracket, 2) the goals one hopes to achieve by converting to a Roth IRA and how much income an individual plans to withdraw from their IRA account, and 3) how much money is set aside to pay the Roth IRA Conversion Tax.  The combination of these factors makes a Roth IRA conversion a very complicated transaction that requires careful analysis.

The marginal tax bracket determines how much tax an individual will pay on the next dollar of income received.  If you are in the 35% marginal tax bracket, you will pay $0.35 in tax for each dollar of additional income.  Converting an IRA to a Roth IRA adds income on top of all other sources of income.  Thus, Roth IRA conversions are taxed at the highest marginal tax bracket possible.  The amount converted can also be large enough to push individuals into even higher tax brackets, increasing the amount of the Conversion Tax even more.  If individuals expect to be in a lower marginal tax bracket in the future, a Roth IRA conversion may potentially cost you more in taxes than doing nothing.

For example, if $100,000 is converted from a Traditional IRA to a Roth IRA, and the highest marginal tax bracket that applies today is 35%, $35,000 of income tax will be owed due to the conversion.  On the other hand, if the IRA were not converted and the future marginal tax bracket is lower, say 28%, then the amount of income tax owed on $100,000 of withdrawals will be $28,000, a $7,000 tax savings.

Even if an individual expects to remain in the same marginal tax bracket in the future or even be in a higher marginal tax bracket, a Roth IRA conversion may do more harm than good.  Consideration of factors such as an individual’s goals and the amount of income needed from the account, and the ability to pay the Conversation Tax are paramount in determining whether a Roth IRA conversion makes sense.

This is perhaps the most overlooked factor concerning Roth IRA conversions. Most advisors simply point out the features of a Roth IRA and do not evaluate whether the end result is consistent with an individual’s goals.  Two common goals of a Roth IRA conversion are maximizing spendable income vis a vis avoiding income taxes, and maximizing the value of assets to pass on to heirs.  Analysis suggests these goals are mutually exclusive and advisors should clearly understand which goal is paramount to the individual.

There is no flowchart or “rule of thumb” that can be applied to the Roth IRA Conversion question.  Individuals must carefully consider their own personal situation in light of their goals.  This includes assessing their income tax situation, their income needs and their desire to either maximize income, or maximize the value of an individual’s assets.  

Maximizing income may or may not be achieved by a Roth IRA conversion, depending on the individual’s income need.  Converting to Roth IRA enables an individual to withdraw only what they wish from the account since Roth IRA are not subject to Required Minimum Distributions.  Essentially, an individual can freeze the amount they withdraw from a Roth IRA and have that entire amount available as spendable income because Roth IRA withdrawals are not subject to income tax.

On the other hand, a Traditional IRA could grow to such a value that eventually, the Required Minimum Distribution exceeds the desired income amount.  Indeed, even after paying the income tax on the distribution, the spendable income could still exceed the amount of income that would have otherwise been taken from a Roth IRA.  Careful analysis of an individual’s situation can help identify this scenario and whether or not a Roth IRA conversion is beneficial.

In another case, the value of an individual’s assets may or may not be maximized by a Roth IRA conversion, depending on an individual’s income need.  It is true that individuals could convert to a Roth IRA, let the assets grow tax-free indefinitely and never make a withdrawal; however, a significant amount of money will be used to pay the Conversion Tax.  This will result in lost growth because money is spent on the conversion tax instead of remaining invested in appreciating assets.

If assets were not converted and left to grow tax-free in a Traditional IRA, their value would be greater because no assets were used to pay any conversion tax.  In addition, any Required Minimum Distributions remaining after meeting the income need and paying the income tax could be reinvested and also grown.  Thus the total amount of the income taxes paid on Required Minimum Distributions could be less than the total amount of the conversion tax plus lost growth that is generated by a Roth IRA Conversion.  Indeed, the growth on reinvested Required Minimum Distributions alone may more than offset the income taxes that must be paid on them.  Again, careful analysis is necessary to understand and identify this scenario.

Individuals have two options for paying the Conversion Tax.  Option 1; withhold some of the amount being converted to pay the tax.  Option 2; pay the tax from other assets available.  Either option is costly, but it is generally better to use option 2.

Option 1 is doubly costly because not only does the amount being converted get reduced, an individual also looses the ability of that money to grow tax-free.  This could amount to a significant amount of lost money.  Going back to the previous example, if an individual paid the $35,000 tax out of the $100,000 that was converted, the amount left in the Roth that would grow tax-free would be $65,000.  The $65,000 growing at 6% tax-free equals $116,405 after 10 years. If the entire $100,000 had been left to grow tax-free at 6% for 10 years, it would equal $179,084.  Thus taking $35,000 out of the IRA, in this case, equals almost $62,680 in lost money.

Option 2 is somewhat less costly.  That is because there is no tax-free growth that is lost on top of paying the tax.  If the $35,000 conversion tax were paid from other assets available, then the $35,000 is no longer able to grow.  The $35,000 growing at 6% and paying 35% income tax would have equaled $51,312 after 10 years, but because it was used the pay the conversion tax, it is equal to nothing after 10 years.  Therefore, $51,312 is the amount of money lost due to paying the conversion tax this way.

One final factor regarding the ability to pay the conversion tax is the special rule for 2010.  For conversions in 2010, the IRS will allow half the income to be recognized in 2010 and half in 2011.  This could be a significant tax savings for individuals that are on the cusp of being in the next higher tax bracket.  However, if an individual does not have other assets available to pay the conversion tax, it is extremely difficult to take advantage of this rule and it is generally not recommended to do so.

A Roth IRA Conversion is a very complicated transaction and it should not be taken lightly.  There are several factors at play that determine the outcome of a Roth IRA Conversion and each set of factors affects individuals uniquely.  Many tools and resources available do not include consideration of these important factors, especially an individual’s goals and income needs.  Careful, comprehensive, and individualized analysis that incorporates an individual’s own situation is strongly recommended.  Frank, straightforward discussions with a knowledgeable, trustworthy financial advisor are the best way to determine whether a Roth IRA Conversion makes sense.