The Roth IRA became available in 1988 and, for the first time in history, allows someone to save for their retirement completely tax-free. This new development has been looked upon as the best thing the government has ever done for investors.
But what if someone has already retired or is near retirement and has accumulated their nest egg in a traditional IRA account because the Roth wasn’t available when they started out? Is there a way they can somehow change their IRA to participate in this tax-free offering that everyone else is entitled to? Fortunately, the answer is yes and the process is known as a Roth IRA conversion. However, there are a few qualifications that must be met before a conversion can take place. This article will explain what those qualifications are and how a conversion works.
As is the case with most IRS rules, there are many exceptions and even exceptions to the exceptions. The following information is intended to provide the basics for those who are interested in learning about conversions. This article will not give the reader all the ins and outs and various exceptions that may exist. For that reason, I highly recommend that anyone reading this article consult with a professional who is experienced in conversions prior to moving forward.
First, if someone doesn’t have any wage income, they cannot contribute to a Roth IRA just as they cannot contribute to a regular IRA. Passive income from investments, real estate or any other source that is not considered wage income cannot be used. Don’t confuse contributing to a Roth IRA with converting to a Roth IRA. Having wage income is not a requirement for a Roth IRA conversion.
Second, to be able to convert to a Roth IRA, one must actually have an IRA (or other qualified retirement account) to convert from. Only IRA funds can be converted to a Roth IRA.
Third, if you have an IRA and wish to convert, your modified adjusted gross income must be less than $100,000 for the year in which you convert. Anyone with an income in that range should check with their CPA or accountant to verify whether they meet this requirement.
Last, if a married couple files separate tax returns, they may not be able to convert at all. Anyone in this situation should investigate these requirements further to see if there are exceptions.
What exactly is an IRA conversion and how does it work? Simply stated, a Roth IRA conversion is the process where an IRA is converted to a Roth IRA. This can be done at one time or over a number of years at the discretion of the IRA owner.
The main benefit is that the investor will be converting from an IRA that will always be taxable to a Roth IRA which will always be tax-free. The main drawback is that the income tax will be due on any amount converted in any given year. It’s a matter of pay me now or pay me later but one way or the other, the IRS will get their tax dollars.
The thought of paying additional taxes now keeps most people from doing a conversion, but this is not a valid train of thought, and here’s why. There are two factors that are pitted against someone who believes that they should wait to pay their taxes later as opposed to now. First, the goal is for an IRA balance to be greater in the future than it is now, especially since many IRA holders have recently lost a substantial amount to the market. Second, since taxes are the lowest they’ve been in history, most financial experts, along with the general population, believe that taxes will rise in the future. If both of these factors prove to be true, then the IRA owner will pay a higher amount of tax on a greater amount of principal by continuing to hold their IRA.
For example, let’s suppose someone has $100,000 in an IRA and the goal is to grow that IRA to $300,000 over the next 20 years. The first obvious question is, which will the amount of tax be higher on, the $100,000 they have now or the $300,000 they will have later? If taxes increase, as is expected, the higher percentage of tax will be due on the $300,000.
The other option is to convert the $100,000 now and pay the lower tax so that the next twenty years of growth will be tax-free. Additionally, if the account value is down because of the stock market, it provides an excellent opportunity to convert to a Roth IRA since the value per share will be lower.
As a side note, the question is often asked as to how high taxes might go. Although the answer is unclear now, what is clear is, contrary to what most investors think, taxes are currently on sale. If you have a hard time believing that, take a look at the following: the top tax bracket from 1946 to 1963 was a whopping 90%, and in 1980, the top bracket was 50%. If you compare these tax brackets to the top tax bracket today which is 35%, you’ll agree that taxes are quite low, contrary to how you feel when you actually pay them.
In addition to the tax savings over the IRA owner’s life, there are more reasons why converting to a Roth IRA could make sense. One benefit is that you eliminate the Required Minimum Distributions (RMD) since a Roth IRA does not require them to be taken during the Roth IRA owner’s lifetime.
A second benefit is that since the taxes are paid on converted funds, the amount of taxes paid is removed from your estate. If your estate is large enough to warrant the paying of estate taxes, then you would have paid 45% (2009) tax on the amount that was removed from your estate during the conversion.
A third benefit is that the Roth IRA funds will be available tax-free upon the owner’s demise. This becomes very important if the IRA contains the bulk of the liquid estate at death. When the beneficiaries need to tap the IRA funds to pay final expenses, those distributions will be subject to both income and estate tax (for estates that qualify), which will add to the expense. Estate taxes are due within nine month of death, and if the IRA is used to pay those taxes, the combined tax could be 85% or higher.
A fourth benefit of converting to a Roth IRA is to provide the beneficiaries with the ability to take their Required Minimum Distribution (RMD) tax-free. Many Roth IRA owners mistakenly believe that their heirs are not required to take minimum distributions from their Roth IRA, but this is incorrect and could be costly. However, as long as the RMD rules are followed by the beneficiaries, all of the income is tax-free. This becomes a much more valuable benefit since the new IRA and Roth IRA rules allow the beneficiaries to take the distributions over their lifetime. For further clarification of these rules, review the article entitled the article, “Inherited IRA” which discusses both IRAs and Roth IRAs.
As with any of the concepts illustrated in these articles, there are many pros and cons and many alternatives that may not have been covered here. The final decision should not be made without seeking professional advice.
