2010 Lane Reports

Conversion of a Traditional IRA to a Roth IRA: A Simple Tradeoff of the Time Value of Money Versus an Option?

The Lane Report, April 2010
Thursday, April 1, 2010 9:00 am
by Janet Iwamuro Wilson, CPA

In 2010, tax laws governing the conversion of Traditional IRAs into Roth IRAs changed, making conversion a viable option for many high net worth individuals.  As a result, many upper-income investors are currently debating whether or not they would benefit from converting some or all of their Traditional IRAs to Roth IRAs. 

As an overview, funds deposited into a Traditional IRA are not taxed, but rather taxes are deferred until funds are distributed at retirement, many years later.  Assuming a taxpayer will be in a lower tax bracket in their retirement years, waiting until retirement to begin taking distributions from Traditional IRAs will most likely result in lower taxes on withdrawals at a lower, post-retirement, tax rate. 

The tax breaks for Roth IRAs differ somewhat as Roth IRAs are funded with after-tax dollars.  Unlike contributions to a Traditional IRA, Roth IRA contributions are not tax-deductible.  While contributions to a Roth IRA may leave taxpayers with fewer dollars to invest in the current period, it allows them the ability to avoid the obligation to pay tax on future distributions. 

In 2010, tax laws changed to eliminate the income test that applies to conversions from Traditional IRAs to Roth IRAs.  Prior to 2010, only taxpayers (other than married couples filing separately) with modified adjusted gross income of $100,000 or less were permitted to convert Traditional IRAs to Roth IRAs.  Others doing so would trigger a tax liability in the year of conversion.  For tax years beginning in 2010, the $100,000 modified adjusted gross income limit on conversions has been eliminated, and married taxpayers filing a separate return are permitted to convert amounts.  In addition, Traditional IRA owners who convert to a Roth IRA after the 2009 tax year have the option of recognizing the income either on the 2010 tax return or spreading the tax payment over two years, paying half in 2011 and half in 2012 (It is important to note that unless a taxpayer elects otherwise, none of the gross income from the conversion is included in 2010; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012).

Though there are many issues to consider when deciding whether or not to convert your traditional IRA to a Roth IRA, let's first consider a basic analysis looking at the conversion to a Roth IRA as a tradeoff between the time value of money versus an option.  By converting to a Roth IRA, taxpayers will incur tax on the amount converted in the current tax year, but will avoid future tax liability on the amounts so converted.  Whereas, if funds were kept in a Traditional IRA, those taxes would be deferred until distributions were taken in later retirement years.  Looking solely at this issue from a time value of money perspective, and applying a conservative growth or discount rates, you would probably make the decision not to convert your tax deferred account to a Roth IRA.  This is because money you pay today in taxes to convert your IRA is more costly to you than having the use of those funds during the time period and then paying the taxes in the future with inflated dollars at a potentially lower tax rate, when you take distributions from your IRA account.    Conventional wisdom holds that any amount of money is worth more the later it is paid out, provided that it earns interest during that period.  If, however, a more aggressive growth rate is utilized and/or one's current tax rate is temporarily reduced for whatever reason (loss of a job, high medical expenses, etc.), conversion becomes a much more appealing alternative.

Converting a Traditional IRA to a Roth IRA does have benefits.  For example, converting a portion of your Traditional IRA to a Roth IRA would provide an alternative source of non-taxable funds to access in retirement.  Looking at the tradeoff as an option to manage the timing and amount of the distributions taken from your taxable retirement accounts, converting to a Roth IRA would allow you the option to limit your Traditional IRA distributions to the annual Required Minimum Distribution (RMD) required by law upon turning 70˝ years of age, taking any additional funds you may need from your non-taxable Roth IRA, as Roth IRAs do not require annual distributions.  This option may be quite beneficial as it would afford you the luxury of avoiding the unnecessary recognition of income in the form of distributions above and beyond your required RMD, which would potentially move you to a higher tax bracket and perhaps cause part or all of your social security benefits to be taxed.

Of course, the decision is not that simple.  There are so many variables that come into play over such a potentially long period of time that making a conversion decision with any degree of certainty becomes, at best, difficult.  Making this decision based on predictions of the future tax landscape is tricky business.  Your decision, in large part, depends upon the future tax treatment of your retirement assets as well as your own personal tax situation in retirement.    

Many advisors feel that if you believe tax rates will increase in the future, you should seize the opportunity and convert your Traditional IRA to a Roth IRA in the current tax year.  But how much would post-retirement tax rates need to increase for your Traditional IRA after-tax distributions to be less than or equal to your Roth IRA tax-free distributions in retirement?  The answer is not simple.  As we said, forecasting what the tax laws will be in the future is impossible, and even more so is forecasting rates of return.  With no end in sight to the current administration's funding requirements and the level of our Federal budget deficit, it's hard to imagine a future without higher tax rates, at the very least for high net worth individuals. 

In addition, future rates of return must also be considered, because the more your assets appreciate in a Traditional IRA, the greater your future tax burden will be.  If, however, your Traditional IRA is converted to a Roth IRA and the markets perform admirably, the argument shifts in favor of conversion as you would have effectively avoided paying tax on the appreciation.  But the issue remains, at what rate?  If that's not enough to think about, consider recent speculation regarding the possibility that future tax law changes could make distributions from Roth IRAs taxable, making the decision to convert to a Roth IRA unsettling. 

Presently, the only assumption that seems likely is that taxes will increase in order to offset the  growing Federal budget deficit.  As a result, if you are considering converting your Traditional IRA accounts to a Roth IRA, it may be advantageous to pay the taxes for the conversion in 2010 and not defer the tax payments to 2011 and 2012 when it is likely that the tax rate will increase. 

Finally, there is the issue of inheritance; Traditional IRAs are notoriously problematic for heirs.  Subject to both estate taxes as well as income tax on mandatory distributions, Traditional IRAs often leave very little for beneficiaries after taxes are paid.  The rules governing Roth IRAs are much more hospitable to beneficiaries.

Even with so much uncertainty surrounding future income tax changes, laws governing Traditional IRA and Roth IRAs, future market rates of return, not to mention the myriad of other unknown factors in the distant future, it is our opinion that it may be prudent to consider converting a portion of your Traditional IRA holdings into a Roth IRA.  This is because, affording some flexibility in retirement to take distributions from a combination of taxable as well as tax-free accounts would give you the option to manage your taxable income to some extent, and allow you to keep some of your options open with regard to future tax law developments. 

Marc Lane (mlane@marcjlane.com) would be happy to discuss in detail the pros and cons of converting your IRA, as each individual situation is unique.

Janet Iwamuro Wilson serves as Equity Analyst / Investor Advocate for Marc J. Lane Investment Management, Inc. Ms. Wilson is a graduate of Northwestern University (B.S.), the University of Chicago Booth School of Business (M.B.A.) and the University of Chicago Irving B. Harris Graduate School of Public Policy Studies (M.P.P.) Ms. Wilson is also a Level II Chartered Financial Analyst (CFA) candidate and is a Certified Public Accountant (CPA).

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