Hot Topic of the Year

The tantalizing advantages of Roth IRAs are available to many for the first time this year. Before 2010, Roth IRA contributions and conversions were unavailable to investors who exceeded certain income limitations. Beginning this year, those limitations have been repealed for conversions – but not for regular contributions. That repeal has made Roth IRA conversions a very hot topic.

Investors have always had an appetite for tax-free returns and have long demonstrated a willingness to pay a reasonable price to obtain those returns. An example would be tax-exempt bonds, which typically have a lower yield to maturity than a taxable bond of similar quality.

Roth IRAs also offer tax-free returns – and not just on bonds, but also on nearly any other kind of investment – only a few types of investments are prohibited. Once an individual has had any Roth IRA in place for at least five years and the individual has reached age 59 1/2, all distributions from the Roth IRA are tax-free. In addition, Roth IRAs are exempt from lifetime required minimum distributions, with the exception of inherited accounts. 

But not everyone is biting. Just as with tax-exempt bonds, there’s a price to pay in exchange for tax-free returns earned in a Roth IRA. The price to pay is this:

• only after-tax dollars can be contributed to a Roth IRA
• regular contributions to a Roth IRA are not deductible for income tax purposes, and
• rollover contributions – also called “Roth IRA conversions – are subject to tax as though a taxable distribution had occurred from the account being converted. For example, converting a traditional IRA worth $100,000 to a Roth IRA will mean paying income taxes now on $100,000, less any cost basis in the traditional IRA.

Weighing the Choices

1.     Roth IRA contributions and conversions only make sense if the anticipated tax-free returns are worth the price of paying income taxes up front.

The value offered by the Roth IRA is the effect, over time, of tax-free investing, to the extent that tax-free investing delivers higher returns than taxable investing. For example, an investor who earns an annual taxable return of 7% percent and who pays income taxes on those returns at the rate of 33 percent has an after-tax return rate of 4.69 percent. It’s the difference between the Roth IRA’s after-tax return of 7 percent and the after-tax return on “taxable” investments of 4.69 percent that makes the Roth IRA valuable over time. As that difference between Roth IRA returns and taxable returns increases, the value of the Roth IRA also increases. For many investors, an increase in future tax rates will drive up the Roth IRA’s value.

Here are two important questions to ask when considering whether to go Roth:

• Will it make me more financially secure, or less so?
• Will it enrich my legacy?

These seem like rational questions. In reality, the seemingly “right” answers are difficult to act on. That is because paying income taxes to invest tax-free within a Roth IRA represents hard dollars going out right now in the hope of realizing anticipated future returns on investments. But how reliable are those anticipated returns? It only makes sense to pay out tax dollars today if there’s a high level of confidence that the investments will perform well tomorrow.

The best way to explore these questions is to prepare a comprehensive financial plan with a competent, reputable financial advisor that takes into account all assets, anticipated investment returns, personal expenses, and legacy plans to see what happens when investment returns or expenses vary. The answers revealed by such an analysis can be surprising.  For example, it’s not always the “right answer” for the charitably inclined to leave a taxable IRA to charity and other assets to children; it might be better to contribute some other assets to charity, with or without a Roth IRA conversion.

Many financial planners and advisors, including those at Bell Investment Advisors, would want to make sure that a Roth IRA would increase a client’s financial stability, not create instability in any way. For instance, using emergency reserves to pay tax liability on a conversion would not make sense; such a conversion could actually create more financial instability.

Another important consideration would be the length of “incubation” time available before withdrawals. In general, the longer the incubation period before withdrawals, the better the odds of success. Certain assumptions are inevitably made by an advisor based on his or her client’s own assessments. “Clients have to make honest, conservative assessments about their ability to postpone withdrawals.  If they say they can wait and are right, then the Roth conversation could make them more financially secure,” says Forrest R. Bell, senior investment advisor and financial planner at Bell Investment Advisors in Oakland, California.  He continues, “If they say they can wait, but in the end they cannot, then the Roth conversation makes them less financially secure. We can only answer the question of financial security in the context of certain assumptions.” 

2. The decision to make a Roth IRA conversion might pencil out, but still, there be dragons.  The ominous creature I have in mind is of the two-headed variety:

• one head consists of our ingrained resistance to paying taxes before we must, and
• the other head consists of our fear that anticipated investment returns won’t work out to be reliable at all.

Some find the monster simply can’t be tamed and so walk away from the Roth IRA conversion opportunity. However, with some additional time, you might learn how to tame your dragon.

If a Roth IRA conversion analysis indicates that it could be beneficial to you, but you are still uncertain, there is an option to keep in mind. A Roth IRA contribution or conversion can be made today, and then can be partly or even completely undone by October 15, 2011, by doing a “recharacterization.”  That move turns the Roth IRA into a traditional IRA, effective retroactively, as of the day the Roth IRA contribution or conversion was made. In effect, it’s as though the Roth IRA contribution or conversion never occurred in the first place, but a traditional IRA stood in its place. If income taxes have been paid, those taxes will be refunded. However, as stated above, even this option is not worth initiating unless careful analysis has revealed there could be a significant benefit to converting.   

Frequently Asked Questions

1. What may be converted to a Roth IRA?

The following retirement plans may be converted into a Roth IRA, provided that such plan is otherwise eligible for a rollover that isn’t a Roth conversion:[1]

• Individual Retirement Accounts, Individual Retirement Annuities, Simplified Employee Pensions or Simple Retirement Accounts, unless the account is “inherited,” meaning the IRA owner’s surviving spouse is not the beneficiary. A rollover from a SIMPLE IRA may not be made within the first two years that an employer has set up at least one SIMPLE IRA for the employee.
• Retirement benefits accumulated in an IRC section 401 traditional (non-Roth) qualified plan trust. This covers most so-called qualified plans offered by employers (401(k) accounts, pensions, profit sharing accounts, etc.).
• An annuity plan described in section 403(a), a special type of qualified plan offered by employers.
• An annuity contract described in section 403(b), a special type of qualified plan offered by employers.
• A qualified military reservist payment, within 2 years after the reservist’s active duty period has ended.
• Certain deferred compensation plans offered by state or local governments.
• A military death gratuity under section 1477 of title 10, United States Code, or section 1967 of title 38 of such Code, except for amounts contributed to Coverdell education savings account under section 530(d)(9).
• Up to $100,000 Exxon-Valdes Oil Spill Settlements, including any interest and punitive damage awards, may be contributed to a Roth IRA by eligible individuals, including lawsuit plaintiffs and beneficiaries of plaintiff estates if the beneficiary is the plaintiff’s spouse or immediate relative.  The payments may be contributed to a non-Roth account without paying income taxes. But income taxes must be paid if paid to a Roth account. See section 504 of the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) or IRS Publication 590. This is not in the Internal Revenue Code.
• An “airline payment amount” to a “qualified airline employee” of certain bankrupt commercial airline carriers. See section 125 of Worker, Retiree, and Employer Recovery Act of 2008 (P.L. 110-458). This is not in the Internal Revenue Code.

2. Who may make a Roth IRA conversion?

• The individual for whose benefit the account was accumulated may make a Roth IRA conversion. So can that individual’s surviving spouse, if the surviving spouse is the beneficiary.

• A non-spouse beneficiary of a plan other than an individual retirement plan may make a conversion to a Roth IRA, but only by direct rollover.

Observation: a lifetime rollover of benefits to a traditional IRA from a non-IRA plan, such as a 401(k) account, to name but one, precludes a death beneficiary other than a surviving spouse from making a Roth IRA conversion.

A required minimum distribution may not be converted to a Roth IRA. Therefore, before making a Roth IRA conversion, distribute the required amount. This includes a distribution for the year when age 70 1/2 is attained, even though that distribution could be made any time before April 1 of the following year. 

3. Will there be a 10 percent tax for “early distributions” (pre-age 59 1/2)?

There is no 10% tax on any Roth IRA conversion. But there is a 10% tax on any converted amount that is distributed from the Roth IRA within five (5) years of the conversion.

4. When are income taxes due on the conversion? 

For Roth IRA conversions occurring in 2010 only, nothing is included in 2010 unless that is elected.  If no election is made, half of the taxable income resulting from the conversion is includible in 2011’s taxable income and the other half is includible in 2012’s taxable income. Because top income tax rates are scheduled to rise in 2011 and beyond if congress does nothing (the rates might well go up even if congress does act), the election to pay the tax in 2010 should be considered. The election may be made as late as the extended due date of the individual’s income tax return (10/15/2011). 

5. How will the Roth IRA conversion affect my 2010 Estimated Taxes and 2010 Filing extension? 

Penalties apply for failure to pay adequate estimated income taxes and for failing to pay tax when due (by April 15). If you make an election, on say November 1, 2010, to pay the tax in 2010, that might affect the amount of estimated income taxes that were due and will certainly affect the amount of income taxes required to be paid by April 15. It is therefore important to consult with your income tax preparer before making the Roth IRA conversion to coordinate tax payments.

6. Should I use non-retirement funds to pay income taxes on my Roth IRA conversion?

In a word, yes. There are several reasons why. Paying income taxes from non-retirement funds maximizes the amount of the Roth IRA. If you withdraw retirement funds to pay income taxes, the amount withdrawn can never be “recharacterized” to a traditional IRA. If you are under age 59 1/2, the 10% tax on early withdrawals will apply to the amount you sent to the government instead of contributing that amount to the Roth IRA. 

Assume You Take the Leap  . . .

1. You will need to contact your investment advisor – or find one – to open a Roth IRA and help you make a direct transfer from the account you will convert over to the Roth IRA. If the account to be converted is not an IRA, you or your advisor will need to contact the plan sponsor, or employer, to obtain the documents you need to fill out and sign. You will want your advisor to read all documents you sign before you submit them.

2. The Roth IRA will have a beneficiary form to fill out. Your goal is allow and encourage your beneficiary to take only the required minimum distributions over the beneficiary’s life expectancy, because that’s how your beneficiary will achieve a lifetime of tax-free returns. This is a form you should review with your investment advisor and/or estate planner. We have seen many disappointed beneficiaries because of mistakes made when filling out that “simple” one-page form. The biggest mistake we see is in naming the estate. Naming a trust should be done only sometimes, and then only with significant input from advisors who really know how to apply the rules on required minimum distributions.

3. If your estate will be subject to estate taxes, your Roth IRA beneficiary is very likely responsible for reimbursing your trustee (or executor) for a share of the tax. Since tax-free investing is likely to be valuable, consider providing a way to pay the estate tax other than by making a large Roth IRA withdrawal, such as life insurance.

A word of caution from Forrest Bell, “For the most part, those who convert and then pay the tax liability with IRA monies do not benefit from converting. Although there are exceptions, almost all of the scenarios I have tested this year demonstrate that it was necessary to pay the conversion tax liability with after-tax money.”

In any case, the decision “to convert” or “not to convert” to a Roth IRA this year is a complex one, and, as with accounting, tax planning, financial planning, and investment management, probably not suitable as a do-it-yourself project. It is simply not possible to calculate the benefits of IRA conversations to the exact dollar; the pros and cons, advantages and disadvantages need to be considered in individual context, preferably with a professional.     

Michael Jones is a partner at Thompson Jones LLP in Monterey, California, an accounting firm devoted exclusively to estate planning. Mike’s articles are widely published in professional journals, and he is a nationally recognized speaker and lecturer. He has been quoted in the New York Times, Forbes, The Wall Street Journal, Bloomberg Financial