Roth IRA conversions: Opportunity or trap?

November 5, 2010

Large IRA accounts pose both income and estate-planning challenges.

Key Points

While it's a nice problem to have, large IRA accounts pose both income and estate-planning challenges. Among other issues, IRAs pass directly to named beneficiaries, so a standard will or trust won't work with IRA assets, which demands extra planning. And, importantly, taxes due upon withdrawal (in the case of a traditional IRA) pass on to the beneficiary, too.

Roth IRAs require special attention. The primary attraction of a Roth IRA is the absence of future income taxes. Account holders contribute after-tax money, which grows tax-free until withdrawal. And while there is a 5-year wait before withdrawing, there are no Required Minimum Distributions (RMDs) in retirement.

Changes in the federal tax code in recent years have made it easier to convert traditional IRAs to Roth IRAs. Under this scenario, the owner of a traditional IRA could turn it into a Roth by making a 1-time payment of income taxes. But before this year, there were stringent rules that prohibited most families with adjusted gross incomes of more than $100,000 from converting.

CONVERSION RULES WAIVED

Those rules were waived for 2010, enabling many more people to convert. There's even a provision allowing the tax to be paid over the following 2 years. Is this an extraordinary 1-time window of opportunity or an attractive trap? That's the question we want to address here.

Overall, converting is a step to consider if you:

But the decision can get a lot more complicated than just answering these questions. It is also an income and estate tax problem, so it is necessarily an individual and/or family. Some families have more money. Even among people making similar salaries, there are multiple factors to consider. How much wealth have you accumulated? How old are you, and how long will you likely live? What about your spouse or parents? Do you have other sources of income? Will any of those sources continue after you die, such as book royalties or rental income?

What about your heirs? How much do they earn? What is their current tax bracket, and what is it likely to be after you're gone?

Another factor to consider is that often there are substantial income taxes due upon conversion. So the decision to convert a million-dollar traditional IRA is accompanied by a sizable check (or checks) to Uncle Sam. To keep this discussion simple, let's assume a 35% marginal tax bracket, and total taxes due of $350,000. Ouch. How's that for a painful mix of money and emotion?

Most people who convert want to keep the full portfolio growing tax-free. To do so, they need to pay taxes from another source, so as to allow the full million to be rolled into the Roth IRA. Where will that money come from? Will productive assets need to be liquidated? What is the opportunity cost of that liquidation?

Finally, any decision to convert is based on certain assumptions. I've heard most of them and they are worth considering: Income taxes are lower today than they will be in the future. Conversion will reduce the size of my taxable estate. Heirs will be spared from paying huge taxes on IRA assets inherited by them. As mentioned earlier, those are all important factors.