Making Sense of Roth IRA Conversions

ponder_elderThe Roth IRA has become a popular planning tool since it was established by the Taxpayer Relief Act of 1997. Originally envisioned as a way for Americans of more modest means to efficiently transfer wealth to the next generation, the Roth IRA offers a number of potential advantages over a Traditional IRA that are particularly attractive to those that are more affluent. While there are many variables to consider when determining which type of IRA is best suited to an individual’s needs, the removal of income limits on Roth IRA conversions has made this tool available to wealthier individuals that would otherwise not qualify to make a Roth IRA contribution because of income-based restrictions.

How does it work?

Assets that are invested in a tax-deferred Traditional IRA or employer-sponsored retirement plan- such as a 401 (k), 403 (b), or 457 (b) – may be repositioned to a tax-free Roth IRA. Because these pre-tax savings plans were not previously subject to tax, the amount converted is included as income and taxed at your marginal or alternative minimum tax rate. The converted assets will grow tax-free, and qualified distributions are never taxed.

What’s the catch?

While conceptually straightforward, there are rules that must be adhered to. Ineligible Roth IRA contributions (including amounts converted) are subject to an excess contribution penalty equal to 6% of the remaining excess contribution at year end. Left uncorrected the penalty continues to grow until a corrective distribution (equal to the ineligible contribution and any earnings) is made. Left unchecked, an error of this sort could be very costly.

In addition, the IRA aggregation rule stipulates that multiple IRA accounts must be combined and treated as one account for purposes of calculating the tax consequences of a distribution, and the pro-rata rule governs the percentage of the account that is subject to tax. In effect, this eliminates the ability to separate pre-tax and post-tax contributions and convert only the post-tax contributions from a Traditional IRA to a Roth.

Who benefits the most from a Roth IRA Conversion?

In general, the people that would benefit most from a Roth IRA contribution will also benefit most from a Roth IRA conversion. These include:

  • People that expect to be in the same or a higher tax bracket in retirement.
  • Those with sufficient cash available to pay the taxes due on the Roth IRA conversion without using retirement funds.
  • Those that may not need the funds for retirement and wish to leave them to heirs.
  • Those with a high investment risk tolerance and long time horizon will maximize the benefits of the Roth’s tax-free growth.

Meet Bob

Bob is a successful forty-year-old accountant that intends to retire at age 70. He expects that his tax bracket in retirement will be similar or higher than it is currently. In fact, Bob is doing so well that he may not need the money in his IRA for retirement and would like to leave a little something to his wife and children. He did, however, hit a rough patch this year and was briefly unemployed before landing a new job. Bob has a Traditional IRA account valued at $90,000 that was funded entirely with pre-tax contributions, and he recently opened a second Traditional IRA that contains $10,000 of after-tax (nondeductible) contributions. Since the account is new and not yet invested, it has no earnings. As a result of his job loss, Bob expects that his marginal income tax bracket will be lower than normal this year. Sensing an opportunity, he would like to convert the after-tax IRA contributions along with $40,000 of the pre-tax IRA account to a Roth IRA.

Because Bob has multiple IRAs, the aggregation rule stipulates that all the accounts will be treated as if they were one IRA. Simple addition tells us that the combined accounts total $100,000 in aggregate. Next, using the pro-rata rule, we determine the non-taxable portion of the account ($10,000/$100,000 = 10%). This tells us that 10% of the $50,000 conversion is not subject to tax and 90% of the total is. After converting, Bob will add $45,000 to his taxable income and now has a $50,000 Roth IRA that can grow tax free.

Don’t let the backdoor kick you…

A final consideration relates to the so called “Backdoor Roth IRA Conversion”, which has been used in recent years by those that are otherwise ineligible to make a Roth IRA contribution because of income limitations. Since there is no income limitation on a Roth IRA conversion, the strategy provides higher-income individuals with access to the Roth IRA.  The concept is simple: after verifying that you have no other pre-tax IRA accounts, make a non-deductible (after-tax) contribution to a Traditional IRA. Next, convert the balance in the Traditional IRA to a Roth IRA. Tax on the conversion is limited to any investment gains in the Traditional IRA, which would presumably be minimal if the account contained no existing funds and the steps are executed in quick succession.

Like all good things, however, the technique is open to challenge by the IRS. If it is determined that the intent of the two steps described above was to make an impermissible Roth IRA contribution, the entire amount could be considered an excess contribution and subject to the 6% penalty.

While there is no surefire way to avoid this outcome, the risk can be mitigated by (a) investing the after-tax contributions in the traditional IRA before they are converted, and (b) allowing several months, and perhaps as much as one year, to pass before converting the balance to a Roth IRA.

There is a lot to like about the Roth IRA, and the removal of income limitations on Roth IRA conversions has made this tool available to those wealthier individuals that tend to derive the most benefit from it. Income and assets alone, however, are only part of the story. The Roth IRA can play a valuable role in most anyone’s retirement income strategy.


forblogs_jm_headJohn Male, CFP®, RICP®
The Gassman Financial Group
The Retirement Maven™
9 East 40th Street
New York, NY 10016
Tel: 212-221-7067

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