Starting in 2010, individuals with any amount of modified Adjusted Gross Income are free to switch a traditional IRA to a Roth IRA and conversions are fully taxable at regular income tax rates. Prior to 2010, to fund a Roth IRA by means of a conversion, a person’s modified adjusted gross income had to be $100,000 or less. Individuals are also allowed to do partial conversions.
I need to bring up that, as of my writing this, Wisconsin has not adopted the federal provisions that allow this conversion and will have different tax treatments for federal and state income tax purposes. Specifically this means that persons who make the conversion and who have modified adjusted gross income over $100,000 will be subject to certain Wisconsin penalties including:
-If the person is under age 59 1/2, he or she is subject to an early distribution penalty.
-The penalty is equal to 3.33% of the amount converted.
-The person is also subject to a 2% penalty for an excess contribution to the Roth IRA (the 2010 Roth IRA contribution limit is $5,000 plus an additional $1,000 catch-up if over age 50).
-This penalty would be applied each year until the excess contribution is withdrawn.
-Persons age 59 1/2 or over would only be subject to the excess contribution penalty.
This Wisconsin issue has received a decent amount of press (in fact the Wisconsin State Journal published an editorial in favor or adopting the federal provision) and I’m optimistic that the state legislature will fix this issue fairly soon. That being said, I will base the rest of this piece on the assumption the provision will be adopted.
Understanding Roth IRA
First off – consider there is a tax bill to be paid that can be very large (based upon your tax bracket) and the amount you convert. So, what would be the tax consequences?
Long-term benefits:
-What people don’t realize is how powerful it is to let money grow tax-free, whereas the growth in a tax-deferred traditional IRA can potentially create more tax issues because that growth could drive up tax brackets as it is withdrawn.
-Roth IRA’s do not require distributions.
Savant Capital Management looked around for software that analyzes Roth Conversions. We were unable to find anything that could show us a good enough answer to the question, “How does this benefit me and how do I measure how much it could benefit me in the future?” We ended up creating our own software that looks at current and potential future income taxes, variable rates of return and the possible length of time that these converted assets would have to grow. We also wanted to “stress test” this using a Monte Carlo analysis. The Monte Carlo analysis uses random hypothetical situations (we use 10,000 iterations) of the above variables.
One thing that becomes apparent is there is hardly ever a case that conversion makes sense if you have to pay for the taxes out of the IRA as opposed to already taxable money. So in other words, if you plan to convert, make sure you have money saved to pay the taxes, instead of using funds from the IRA.
Longevity makes a Roth Conversion even more desirable (if you are younger – it is better), but you can also consider that someone who is older and has this money tagged as a legacy would also be a decent candidate. The longevity would come from the length of time your kids could potentially keep this money tax-free.
Paying the Tax
So we know that income tax is due on pre-tax amounts of the conversion. The 2010 conversion rules also give a couple of options to pay the taxes:
-The taxes can be paid on your 2010 tax return or
-You can elect to split the income between 2011 and 2012 (this is an all or nothing election)
Let’s talk about the income split – there may be a potential downside. Beginning in 2011, tax rates that were in effect prior to 2001 return. The top income tax rate goes back to 39.6 percent, and the special low 10 percent bracket is eliminated. So we could potentially see a higher tax bill (assuming other income remains the same) by opting for the 20011-12 split. Just looking at the national debt, it also wouldn’t be hard to rationalize that taxes could be raised even more. There is nothing that says that you can’t do an independent and partial Roth Conversion each year.
What you should do if you convert
Based upon the dialogue above and looking at the viability of converting (through the use of the afore-mentioned software), I think there is some fairly standard advice to give. Take the amount you are converting (whether it be all or part of the existing IRA) and divide by three. Convert the first one-third right now to be paid on the 2010 tax bill. Towards the end of 2010, we’re going to take a hard second look at the potential 2011 and beyond taxes. Given what we see at that point – we may decide to convert more before the end of 2010.
You can change your mind and “recharacterize” your conversion back into a traditional IRA any time up to the income tax filing deadline for the tax year of your conversion, including extensions. You would potentially want to do this if the investments you made in your converted Roth went down in value by any significant amount. You can even change your mind again and turn it back into a Roth once again (after some time constraints are addressed).
One last thing to mention – if you don’t happen to have a lot of taxable income and you still have deductions, you might be able to make a small Roth conversion at almost no cost. The combination of a small amount of taxable income and deductions could create a “negative” tax bill. The Roth conversion, up to the point of having zero taxable income instead of negative income, could make this a nontaxable event.
Morningstar Article: Paying for a Roth IRA Conversion?
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