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Financial Life Advisor
Roth IRA Conversion in 2010
I have several 401k plans that I am considering transferring into a ROTH IRA in 2010 given the one-year holiday from the income phase-out, which has disallowed me from participating in a ROTH. However, I currently live in a high-tax state and am in a high tax bracket. I may move to a lower tax-rate state in the near-future but would expect to stay in the same federal tax bracket. I am unsure how the state income taxes could affect the cost-benefit from switching the 401ks to ROTHs. Also, I am unsure how state-income taxes would, if at all, be paid, and over what period given that you are allowed to spread the associated tax payments over 2011 and 2012 (I believe). Could you go through what factors I should be considering and the potential impact of converting a 401k to a ROTH, particularly what state income tax considerations I may be unaware of?
J.H. from New York, N.Y. J, the idea of tax-free growth and withdrawals in the Roth IRA is a powerful concept, and it seems like a no brainer to convert when given the opportunity. However, there are several considerations that you should think about before deciding the conversion is right for you. The first concept most people have trouble wrapping their heads around is that a Roth IRA, being tax-free, will net the same after-tax benefits as using a traditional IRA when the income tax rate is the same during contributions, conversions, and distributions.
Let us take an example of someone who wants to save $1,000 in a Roth IRA. This person is in the 25% tax bracket. If they decided to contribute to a traditional IRA instead, they would be able to save $1,333 in the traditional IRA with the same out of pocket cost. How is this possible? Well if this person contributes $1,333 to a traditional IRA, that contribution is deductible, thus saving them $333 in tax they would have had to pay if they had made the Roth contribution instead. Thirty years later when the $1,000 in the Roth IRA has grown to $10,000, an identically invested traditional IRA with the $1,333 would grow to $13,330. When the $13,300 is taken as a distribution, 25% goes to taxes (assumes the same bracket), and that person is left with the same $10,000. At the end of the day, both the traditional IRA and Roth IRA have the exact same “value”.
Obviously income tax rates and income tax brackets do change over time. Being able to predict what the rates and your income will be in 5 years is hard, but to predict it in 30 years is nearly impossible. Current tax rates are at historical lows, and many people feel that tax rates must go up from current levels. Our current President has indicated that he wants to raise income taxes, particularly on higher income earners. There is also a possibility that Roth accounts could be taxed in the future or subjected to other changes which would diminish their benefits. As stated before, it is hard to know what the tax landscape will look like in the future, as things always seem to change.
The Roth IRA has two subtle differences which can have a significant impact on retirees. Unlike the traditional IRA, distributions from a Roth IRA do not count towards making Social Security benefits taxable. Many retirees find themselves in the situation where taking traditional IRA distributions can cause both the distribution amount and their Social Security benefits to be taxable. This can create effective tax rates for that traditional IRA distribution which are much higher than expected. The second difference is that the Roth IRA does not have Required Minimum Distributions (RMD). The Roth can continue to grow with no requirement late in life to take distributions as taxable income. Although these two items are subtle, they definitely are advantages of the Roth IRA. For retirees with significant income in retirement, the Social Security calculations will be a non-issue, as other income will most likely make Social Security benefits taxable.
You specifically asked about the special provision in 2010 which allows anyone (regardless of income) to convert their traditional IRA into a Roth IRA. Currently, conversions are only allowed for tax filers with incomes less than $100,000 (2009). In 2010, anyone can convert their IRA regardless of income, and the amount of any Roth conversion is taxable as ordinary income. The other twist special about 2010 is that the conversion can be split over 2011 and 2012 to ease the tax burden of the conversion. So, for instance, if someone was to convert their $100,000 traditional IRA into a Roth IRA in 2010, they could take $50k in income on their 2011 and $50k on their 2012 taxes or all $100k+ in 2010. The question on whether or not the conversion makes sense from a tax savings perspective mostly comes down to the tax rate you pay when making the conversion and what it will be when you withdraw it.
Let us assume a typical upper-income individual ($100k -$250k/yr) who has a steady income decides to take advantage of the Roth conversion in 2010. By converting the traditional IRA, they are increasing their taxable income by the amount of the conversion. This would quite possibly increase the tax bracket they fall into and, therefore, the tax rate of the conversion. When they retire, they may not have the same high level of income they did while working and they would most likely be in a lower bracket. If this is the case, it probably does not make sense pay a higher rate now to save a lower rate later. Some argue that even with a lower bracket and lower income, the Roth still might make more sense because tax rates could rise significantly and ultimately be higher than during their high income earning years.
Other factors may also make the conversion more attractive. If you are in a circumstance where you will have a lull in income during the conversion period (e.g. getting an MBA or starting a new business), or if you expect to inherit significant wealth, there may be opportunities because of an imbalance either for the years of conversion or planned retirement distributions. In your question, you specifically asked about moving from a high tax State to a low tax State. Generally, States will look at the conversion as ordinary income and tax it just like your other ordinary income. Each State is different, so you should consult a tax professional familiar with your particular State or city rules. Since the conversion would add to your ordinary taxable income, a lower tax State would effectively be a lower tax rate. If you plan to retire in a high tax State, then you would probably have an advantage converting in a lower tax State.
You will have to make a personal determination on where your income will be and what tax rates will be. As an advisor, it is hard for me to recommend paying more tax at any time. Generally, I recommend deferring tax where possible because you never know with total certainty what will happen with tax rules or personal income. If you convert all of your traditional IRA assets into a Roth IRA and then become permanently disabled, you would probably have been better off not paying the tax because your income would be permanently reduced.
The other major question you will have to address after the tax rate question is how you will pay the tax due. If you use funds from the traditional IRA for the tax due on the conversion, you do not avoid the 10% early distribution penalty if you are under the age of 59 ½. So if you have non-qualified (taxable) assets available to pay the tax, it is like you are converting those non-qualified assets to a Roth IRA because it maintains the full traditional IRA balance (generally pre-tax) in a Roth (tax-free). The 10% penalty would not apply for someone 59 ½ or older, but using traditional IRA assets to pay the tax burden still would diminish the value of the conversion.
I can tell you from personal experience that it keeps more planning options open when our clients have traditional IRA, Roth IRA, and non-qualified taxable accounts. This allows for much more flexibility in structuring investments for tax efficiency and help control the amount of ordinary income that is taken each year. You are not required to convert your whole traditional IRA in 2010 and should consider a partial conversion. Other reasons you may want to convert to a Roth include reducing the size of your taxable estate for estate tax purposes or if you plan on needing large lump sum distribution in retirement (e.g. major home renovations, big trip). The Roth provides a tax-free way to access large sums without raising your taxable income inordinately for one year.
J, I don’t know how old you are, but here is what I would recommend. If you are under the age of 59 ½, there is no way I would recommend you convert to a Roth unless you have money outside of a tax shelter to pay the tax. It will be very difficult to make up for the 10% penalty otherwise. Be mindful of the high tax/low tax States situation. If you can convert in a lower tax State, it will be a plus to conversion. Also, if you seriously expect to have a higher income in retirement than you do now due to above average savings or a windfall (e.g. inheritance, significant pension), then those are pluses for conversion. If you are very convinced income tax rates will rise dramatically, then that is a major plus for conversion. If you are over 59 ½, having assets to pay the tax on the conversion is better but is not as much of a deal-breaker as for someone younger.
You also should look at your overall savings, having money distributed between traditional IRA, Roth IRA and non-qualified investments. This gives greater flexibility in retirement. You do not have to convert all of your traditional IRA funds either. You should weigh your expected tax bracket in 2010 vs. spacing it out over 2011 and 2012. The indications out of Washington are that we will see higher tax brackets in the near future. A 2010 full conversion may be better than spacing it. Keep a close eye on tax rates and the rhetoric out of Washington.
Hope this helps you make a decision.
Posted by Ben Gurwitz on 10th August, 2009 | Comments | Trackbacks
Tags: Financial Planning, Tax Planning
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