By: Frank Armstrong, CFP, AIF
The distribution options after the traditional IRA’s required beginning date leave more than a little to be desired. As discussed in previous columns, investors are likely to find that neither the IRA’s distribution schedule during their lifetimes nor the ability to leave IRA assets to their beneficiaries perfectly fits their needs.
Good thing there’s another option for investors with adjusted gross incomes of less than $100,000 (excluding the income from conversion): converting all or part of a traditional IRA into a Roth IRA. If your tax-filing status is married filing separately, a conversion is not allowed at any income level. But if you are eligible, a Roth conversion can be done at any time during your lifetime. Until 2002, however, any required distribution after the required beginning date must be counted as part of your adjusted gross income. This means that if a distribution pushes your income above $100,000, you will not qualify for a conversion.
In this column, I’ll cover the benefits and drawbacks of converting to a Roth IRA, as well as what you should consider before making the change.
Even the Downside Can Be Beneficial
The benefits to conversion can be numerous. For starters, conversion puts investors in control of their assets. With a Roth IRA, you’re no longer forced into an inconvenient distribution schedule after age 70 1/2. And the ability to convert after the required beginning date allows investors to “cure” an inappropriate beneficiary designation and modify what otherwise would have been an irrevocable set of choices. Furthermore, Roth IRAs offer extended tax-free compounding to beneficiaries. Finally, because Roth IRAs carry no income-tax liability (unlike traditional IRAs), they can be placed into a Uniform Credit Shelter without income-tax “waste.”
There seems to be one big downside, though: The conversion is taxed as ordinary income in the year the IRA is converted. Knowing that deferral is a great tax strategy, you may be reluctant to pay the conversion tax now. But remember, minimizing taxes is not as important as maximizing the after-tax value of the IRA in the future for yourself and your beneficiary. Paying the tax now may result in higher after-tax values in the future. In fact, paying the income tax upon conversion lowers the size of your estate for estate-tax calculations, which may be a significant benefit for larger estates.
Doing More than the Math
Answering the question of whether you should or shouldn’t convert would be pretty simple if the only issue was income for you, the IRA owner, during your lifetime. The answer would rest solely on your tax brackets before and after conversion.
- If your tax bracket in retirement is the same as before retirement, you derive no benefit or harm from converting.
- If your tax bracket is higher in retirement than it is now, you benefit by converting
- If your tax bracket is lower in retirement than it is now, you suffer a loss by converting.
If only things were so simple. The twin issues of estate implications and forced distribution after the required beginning date may tilt the analysis in favor of the Roth, even if your tax bracket is the same or lower in retirement. Why? Three reasons.
- Roth IRAs have no required beginning dates. As a result, there is no “force-out” during the lifetime of the owner. Roth IRA owners are free to make withdrawals or not, as they choose. (Withdrawals cannot be made for five years after conversion and until after the owner turns 59 1/2, however.)
- When the owner dies, a spousal beneficiary is free to convert the IRA to his or her own Roth IRA.
- A nonspousal beneficiary may withdraw tax-free income over his or her remaining life expectancy. There will never be a meltdown situation.
So, what if conversion would force you into a higher tax bracket? Each time you move into a new tax bracket because of a conversion, the attraction of the conversion on a tax basis does, in fact, lessen. But if you have a large IRA, are concerned about forced distributions, or want to preserve the IRA’s value for future generations, a number of smaller conversions over a period of years could control tax-bracket creep. A financial professional can help you determine an optimum conversion amount that will maximize benefits for beneficiaries at any time in the future.
For a comprehensive library of articles devoted to the subject of Roth IRAs and conversions, visit the Roth IRA Web site. Conversion calculators of varying capabilities are widely available on the Internet. And as always, be guided by your professional tax advisors.
I’ll embark on a series of columns about the rise of modern financial theory and the practical applications for investors. Watch for my first installment on Thursday, January 27.