A Roth IRA is created with post tax assets and grows tax free until distribution. Upon distribution, the account owner or the chosen beneficiary can withdrawal funds tax free.
Not just traditional IRAs are eligible for a Roth conversion. You can convert almost any tax deferred retirement account including 401ks and profit sharing plans.
An inflection point in financial planning
The 2011/2012 period presents a unique opportunity for financial planning as they are the last years for the top marginal tax rate of 35% (it reverts to 39.6% in 2013), and there is no income limitation on the conversion of retirement assets into a Roth IRA (prior to 2010, it was subject to AGI limitations).
While there are many on-line calculators available to help determine if a conversion is right for your situation, they all suffer from the same weakness: you need to make too many input assumptions and this creates too much uncertainty in the result.
We offer the following advice: Get comfortable with the ambiguity of the results and don’t let that prevent you from making a potentially rewarding financial decision.
Focus on the items that matter
By far the biggest advantage to converting retirement assets to a Roth is the potential to reduce your taxable estate. The other aspects of the conversion are relatively minor in comparison.
How you pay your tax liability: If you are able to pay the tax liability of the conversion from assets outside the retirement account , you will effectively pass the full amount of your retirement assets onto your heirs without estate tax consequences. Considering you must pay ordinary taxes on your retirement account at some point anyway… plus estate tax, this is by far one of the most compelling aspects of the Roth conversion as it eliminates the estate tax liability from your retirement account.
How you fund your retirement: Being able to fund your retirement outside of your Roth assets will allow you to further reduce the size of your taxable estate. This is a very attractive aspect of the Roth conversion because you will always have the option to withdraw funds from the Roth IRA if needed, but you should plan on reducing your liquid taxable estate to zero before you do this. Illiquid estate items such as houses and privately held businesses will be applied against your estate tax exemption, but you will be able to exclude the Roth funds from estate tax.
Other relevant but less important items
Size of your retirement assets: At its most basic level, the Roth conversion is about the amount of taxes you will pay upfront during the conversion versus the amount of taxes you will pay during the time you would make withdrawals otherwise. Traditional IRA’s ‘force’ withdrawals through Required Minimum Distributions (RMDs), plus the size of your retirement assets will force you into realizing a certain level of income during your retirement. The bigger your account, the more income you will realize in a traditional IRA as RMDs and the more beneficial a conversion would be with today’s lower top marginal tax rate.
Your age: IRAs can be converted to a Roth at any age but the advantage of doing it sooner rather than later is the increase in time the assets have to grow tax-free. A Roth account will not have RMD requirements so you will have a longer time period to grow your assets. Keep in mind that if you convert before you are eligible to make distributions from your retirement account, you must pay your tax liability from outside your Roth or face early withdrawal penalties.
Don’t focus on the items you can’t control: Asset returns and the uncertainty of future tax laws.
While everyone would prefer more clarity on the benefits of a Roth conversion, the unfortunate reality is that returns on the overall market will have a large impact on the benefits of a Roth conversion. Equity markets have historically returned an average of 12% per year and with a sufficient time horizon, you should be able to realize something close to this.
Estate tax considerations are even more ambiguous in the present environment. It is fairly safe to assume that estate taxes will be reinstated at some point in the not so distant future at exemption amounts that are higher than the amounts currently required.
Making a decision … and then taking it back
One of the more interesting aspects of the current law is that you can make the decision to convert to a Roth IRA and if the market doesn’t cooperate, you can re-characterize your Roth IRA back to a traditional IRA (subject to certain restrictions). For example, you make a conversion, pay your tax liability and then the market goes down by 50%. You can simply re-characterize your IRA back to a traditional and then pay taxes off of the lower account value during a conversion or withdrawal at a later date.
The final analysis…
As with any big financial decision, a Roth conversion merits more than just casual analysis. If you have answered ‘yes’ to any of the four questions, a more detailed analysis of your situation with a tax accountant is your next best step. Use our Roth Conversion Calculator to help analyze your current situation. This calculator is not intended to give tax advice. It’s an educational tool based on interpretation of current federal tax law and IRS regulations, which are subject to change. Because state tax laws vary, this calculator doesn’t take state taxes into account.