Roth IRA Conversion

Retirement accounts represent the largest asset of many estates. And even after the market’s decline, retirement fund balances are still sizeable. Furthermore, most of these dollars are exposed to income and estate taxes at the owner’s death.

The idea of a traditional IRA is to allow tax-deferred growth. However, a Roth permits tax-free growth that can continue after death.

The tax-free feature of the converted Roth will eventually build larger retirement account balances for ira ownersand their beneficiaries. And the new law has established low tax rates that will make Roth IRA conversions less expensive.

However, some people may not be able to convert because their adjusted gross income exceeds $100,000 (same figure for singles and couples). Here are some ways to reduce income on your tax return so that you can qualify for a Roth.

Take stock losses

• Use passive losses, such as rental properties
• Contribute to Keogh, SEP, and SIMPLE IRA
• Convert taxable income to tax-free income
• Defer business income or receipts

Here are the savings of converting a traditional IRA to a Roth IRA:

Assumptions: IRA owner age 65 grows IRA for 20 years until death. Mandatory distributions taken from other IRA funds so unencumbered growth occurs in regular IRA. All funds earn 6%, combined tax rate of 33%. Roth conversion tax is paid from non-IRA funds.

How to Calculate the Savings on a Roth—Review the Estate Advantages and Surviving Spouse Advantages

Roth contributions are not deductible. However, they grow tax-free for beneficiaries who will inherit more because of this extra growth. If the IRAs are not converted, there would be taxable required distributions over the life of the IRA owner. That would leave much less for beneficiaries. Also, once the beneficiaries inherit the traditional IRA as opposed to the Roth IRA, the beneficiary’s required distributions will be taxable, further decreasing the growth potential.

A Roth conversion can help you reduce taxable estates and leave more for survivors. Since IRA owners, upon conversion, must pay income tax on the amount converted, this amount reduces their estate. Thus, the government is paying for part of the conversion. This can be a break, especially for older, wealthier retirees.

Case Study

Harry is 65-years-old and single. He has a $1 million traditional IRA and other assets that put his estate in the 47% marginal tax bracket. Harry understands the Roth’s benefits but is less than enthusiastic about paying $350,000 in income tax (35% federal) for the conversion. He rationalized that he doesn’t have enough years to make up the out-of-pocket tax cost. However, a review of the tax savings for his heirs convinced him differently, and he made the conversion.

Since Harry reduced his estate by $350,000 (income tax paid on the conversion), he cut his potential estate taxes by $164,500. Thus, the IRS picked up part of the cost. And his beneficiaries stand to inherit his $1 million Roth IRA from which they can withdraw income for the rest of their lives, income tax-free . Otherwise, if the funds had been left in the IRA, they may have had to pay up to 35% on the distributions.

The possible tax savings: Estate Tax - $164,500

Income Tax - $350,000

Total: $514,500

Suppose that Harry lives another 15 or 20 years and earns 7% on his retirement funds? (Illustration does not reflect Harry’s RMDs.)

Roth Conversion in Steps

Retirees of any age with large IRAs must understand that their IRAs can be hit with estate and income taxes when they die. And RMD rules could cause future income tax burdens while they are alive. However, clients between ages 59½ and 70½ have a great opportunity to use the new tax law to their advantage.

If they have modest incomes are in lower tax brackets (10% or 15%), they can remove just enough money from their IRAs to use up those brackets. When they turn 70½, they will have reduced the amount subject to RMD. Their future tax brackets may be lowered because of smaller withdrawals, and they will have shifted more of their assets out of their IRA. And most assets held outside an IRA pass income-tax-free to beneficiaries. Additionally, those distributions at low tax rates can be converted to a Roth IRA.

Case Study

Bill and Linda are both retired, have large IRAs, and are age 60. Their taxable income will be $30,000 this year.

The new tax law extends the 15% tax bracket to $59,400 for couples filing jointly. Thus, Bill and Linda could convert $29,400 worth of their IRAs to Roth IRAs this year and fully use up their 15% tax bracket.

The federal income tax rate on the $29,400 conversion will be 15% ($4, 410). And after Bill and Linda hold the Roths for five years, they can withdraw the money tax-free. Each year they will repeat the process and continually shift a large portion of their IRA to a Roth.

If Bill and Linda had waited until they were 70 ½ and subject to RMD, the withdrawals may have pushed all of their income into a higher tax bracket.

IRA Distribution Client Newsletter