From time to time we will be sharing insights from some of the people in our network of professional advisors who assist our clients with tax advice, estate planning, and other issues.
Following is an interview with Michael J. Reilly, CPA, Partner in Charge of Tax Services at Dannible and McKee, LLP—Certified Public Accountants and Consultants. In this interview Mike addresses some of the issues surrounding Roth IRA conversions.
Mike, are you actually seeing many clients converting a traditional IRA to a Roth IRA?
We are seeing many clients asking for information and a few clients converting. While the tax appeal for a conversion is compelling, everyone’s tax situation is unique. The major reason clients are not converting is the cost of paying taxes now compared to receiving tax benefits in the future. Also, there is some concern that Congress may change the rules and start to tax Roth IRAs. However, in my opinion, I think it is unlikely that Congress will re-tax converted amounts that have already been taxed.
What are some of the benefits of converting?
The primary rationale for converting is if you conclude that your future tax bracket will be higher either because tax rates will be higher or your income will be greater. Another advantage is that a Roth IRA is not subject to the required minimum distribution (RMDs) rules starting at age 70 and ½ for the current owner. However, the beneficiary of a Roth IRA will be required to take RMDs after the owner’s death over the beneficiary’s life expectancy.
Do I owe both federal and state income taxes on the conversion?
Conversions are subject to both federal and New York income taxes.
Have you seen clients plan to convert a portion of the IRA over several years?
Yes. The Roth IRA conversion is not an “all or nothing” proposition. An individual may make a partial conversion. One strategy is to convert over a period of years. A conversion is not a one-time event. Under New York income tax law, the first $20,000 distribution from an IRA is not taxable. Converting over a period of years can be an effective tax strategy, especially if the taxpayer is in a low income tax bracket or has losses or deductions that will offset some or all of the income from conversion. For example, I have one client whose deductions exceed his income by about $20,000 each year. He has a traditional IRA with a current balance of about $120,000. Therefore, we are going to convert $20,000 a year over six years to his Roth IRA. As a result, the conversion will be completely tax-free.
Does a conversion make sense as an estate planning tool?
Leaving a traditional IRA to your heirs means they might pay federal taxes twice—once on the estate and again when taking distributions. On a conversion, the income taxes paid reduce the estate’s value. Your beneficiary may save money by avoiding paying the estate tax. Also, your heirs will not need to pay income taxes on the Roth distributions. Of course, estate planning is a very personal matter that requires professional help.
Does a conversion make sense for someone who is already retired?
A Roth conversion will reduce the value of your traditional IRA, thereby lowering the amount of future RMDs and your taxable estate. However, the conversion generally does not make sense if the taxpayer needs to take distributions for living expenses. In this case, the individual might as well defer the tax until the future distribution date.
Can a conversion affect Social Security benefits and Medicare premiums?
Yes. First, let’s look at Social Security. A Roth conversion could mean a one-year increase in the portion of your benefits that may be taxable. A Roth conversion will raise your total income (for Social Security purposes, defined as half of your benefits plus any other income, including tax-exempt income), and it’s this income level that determines what percentage of your benefits are taxable (0%, 50%, or 85%). But keep in mind that distributions from a Roth won’t affect the taxation of your Social Security benefits, and that may help you in the long run.
Medicare premiums work a little differently. Premiums are based on one’s modified adjusted gross income (MAGI) from two years prior, which means your 2010 premiums are based on your 2008 MAGI. Since a Roth conversion this year will increase your 2010 MAGI (if the income is reported this year), your Medicare premiums might rise in 2012.
Mike, any other thoughts?
Yes. First, it is important to note that generally, for the conversion to make sense, the individual should use funds outside the IRA to pay the tax on the conversion which allows the individual to benefit from greater tax-free yields. Second, if you decide to convert and later find out it was not such a good idea, you can “undo” the conversion up until October 15th of the year following the year of conversion; thus the individual has the benefit of 20/20 hindsight. Third, for those who are charitably inclined, it may make sense to do a Roth conversion in tandem with charitable giving strategies. For example, an individual could do a Roth conversion and set up a charitable lead trust (“CLAT”) at the same time. The way a CLAT works is that an individual transfers funds to a CLAT, whereby distributions are made from the CLAT to a charity over a specified term and at the end of the term, the remaining assets in the CLAT are transferred to the donor’s heirs. The donor receives a charitable tax deduction for the present value of the annuity stream that is to be paid to the charity in the year the CLAT is funded. This charitable deduction can then offset all or a portion of the income generated from the IRA conversion to the Roth IRA.
Should you be fortunate enough to have a sizable traditional IRA, is it worthwhile to have a discussion with your financial advisor or accountant on your particular situation?
Yes. As discussed previously, each individual’s situation is unique and should be analyzed to determine whether or not such individual could benefit from a conversion to a Roth. This is a complex area and taxpayers should not shortchange themselves by not investigating this potential planning opportunity.