Magazine article The CPA Journal

The Roth Conversion Question

Magazine article The CPA Journal

The Roth Conversion Question

Article excerpt

Forecasting Future Market Scenarios Helps Determine the Best Strategy

Roth KAs, despite their attractive features, have yet to match the popularity of traditional individual retirement accounts. Of course, one reason Roths constitute such a small percentage of total retirement assets (just 5%) is that many wealthier individuals - who potentially stand to benefit the most from them - have been ineligible either to contribute to one or to convert their existing traditional IRAs to Roths.

But as of January 2010. the IRS income ceiling for Roth conversions has disappeared, presenting investors of means with an interesting quandary: If they convert, they will accelerate taxable income into an earlier year, which flies in the face of the cardinal rule that you pay no tax before it is due. On the other hand, a Roth, unlike a traditional IRA, would enable both tax-free withdrawals and the avoidance of required minimum distributions (RMD) - allowing more wealth to grow tax-free for a longer period of time. It's not an easy decision.

To cut through the uncertainty and provide a framework for weighing the pros and cons of conversion, the authors applied quantitative wealth forecasting analytics to model future market scenarios, focusing on the three key variables involved in the decision: investor tax rates, spending needs, and time horizon. Our research suggests that the best conversion candidates are those who can afford to pay the cost of conversion from their taxable assets and fit any one of the following criteria;

* They don't expect a significant decline in their effective tax rate in retirement.

* They are making the conversion at a younger age.

* They don't expect to spend meaningfully (or at all) from their IRA or will begin drawing from it only much later in their retirement.

* They intend to transfer their IRA at death to beneficiaries who will then "streich" it.

The Basic Math of Roth Conversions

At first glance, it may appear that the decision to convert would depend solely on a guess about future tax rates: Favor the Roth if you anticipate higher lax rates down the road, and stick with a traditional IRA if tax rates are expected to fall in retirement. However, the Roth offers two advantages over a traditional IRA that can make it far more appealing to high-networth investors - even if their tax rates are likely to fall in retirement:

* Grow more wealth tax-free: To the extent that investors can pay any tax due from converting to a Roth from a taxable account, they can shift more of his wealth into a tax-free savings vehicle.

* For longer: Because they are exempt from RMDs, Roth dollars can grow taxadvantaged for a longer time period.

Let's look at the first advantage. Although it may be tempting to pay the tax using funds from the IRA - as this is what generated the tax liability in the first place - by doing so, an investor loses out on what is likely the biggest potential advantage of the conversion: the ability to shift a greater percentage of one's total assets into a taxfree account. This has the same effect as making an additional, sizable contribution to your IRA, something you would not otherwise be allowed to do.

Now for the second advantage of a Roth. The rules for traditional IRAs stipulate that investors start taking required minimum distributions at age 7O1A That's the equivalent of withdrawing between 4% and 5% of the IRA's balance each year between the ages of 7 1 and 80, and over 6% of the balance annually between ages 81 and 90. But that law doesn't apply to holders of Roth IRAs, who need never draw from the account during their own lifetimes (although the owner of a nonspousal inherited Roth IRA does have to take RMDs).

To see these two advantages hi action, let's consider a 65-year-old investor who has $ 1 million in a traditional IRA and a blended federal/state tax rate of 45%. Assume he has enough in personal assets to pay the tax bill of $450,000, that his effective tax rate will not change in the future, and that he doesn't need to spend from the account. …

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