Everyone with a traditional IRA should be looking into whether converting to a Roth IRA might make sense for them, because the ability to shelter future earnings from taxation is a very attractive feature of the Roth. The difficult part in doing a conversion analysis, however, is in forecasting the tax bracket that will apply when the IRA monies are distributed in the future. For alternative minimum tax payers, the Roth analysis can be especially difficult.
Roth IRA vs. traditional IRA
Contributions to a traditional IRA are tax-deductible when made, subject to income restrictions and other limitations. In return, distributions taken from the IRA, typically in retirement, are taxable, along with the earnings on the IRA while it was invested. For a Roth IRA, on the other hand, there is no tax deduction when the contributions are made, and in return there is no taxable income at the time of taking distributions. The feature particularly attractive to a Roth is that the earnings also are not taxable.
Roth conversions
Prior to 2010 there were income limits on who was allowed to convert a traditional IRA to a Roth IRA. These income limits prevented most folks who had the wherewithal to make such a conversion from being able to do so. The removal of these income limits has resulted in a lot of articles being written on this issue, and many investment advisers continue to meet with their clients to try to figure out whether or not a conversion sense for them.
The basics of a Roth conversion are simple. In exchange for paying taxes now, an individual will pay no taxes when the monies are withdrawn from the IRA. Sounds simple, yes, but the analysis actually is pretty difficult because of the variables involved, particularly the individual’s tax rates, both now and in the future.
Example
Assume an individual has a traditional IRA with a balance of $100,000, and has been able to deduct all of the contributions that have been made to it. If that individual is in the 35 percent tax bracket, electing to convert it to a Roth today will mean tax due of $35,000. The remaining balance of $65,000 will continue to be invested, and at retirement there will be no taxes due on the $65,000 or on any of the investment earnings. If one assumes investment growth of 50 percent between now and retirement, the individual will end up with a tax-free distribution of $97,500.
Compare this to leaving the IRA alone and not making the conversion. Fifty percent growth will mean the IRA will be worth $150,000 at retirement, before tax. If the individual is still in the 35 percent bracket, the tax will be $52,500, leaving a net amount for the individual of $97,500. How interesting, one notes – the result is exactly the same!
Tax planning for a Roth conversion
So now you know the "secret" behind the Roth conversion analysis – investment yield is irrelevant. The entire analysis is in the tax rates – what tax bracket you are in today vs. what tax bracket you expect to be in at retirement. With Republicans fighting Democrats over who is and who is not "rich," and continuous last-minute temporary "extenders" of our individual income tax rates it is, in fact, almost impossible to do with any degree of accuracy. But that doesn’t mean the analysis shouldn’t be done. Set forth below is all the information you need.
What tax bracket are you in in 2011?
Using the married-filing-jointly status as an example, here are the 2011 tax tables, if you are paying the Regular Tax:
Up to $17,000 10%
Excess up to $69,000 15%
Excess up to $139,350 25%
Excess up to $212,300 28%
Excess up to $379,150 33%
Over $379,150 35%
Here are the tax tables, if you are stuck in the Alternative Minimum Tax:
Up to $175,000 26%
Over $175,000 28%
What tax bracket will you be in after you retire, at the time of taking the IRA distributions?
This, of course, is the really hard part, especially in view of the ongoing push from some of our leaders in Washington (i.e., the Democrats) to raise our tax rates. There are three choices in how to approach this:
One is to assume you will be in the Regular Tax, and that the Republicans will somehow keep our tax brackets the same as they are today. In this case, use the Regular Tax table shown above.
Another is to assume you will still be stuck in the AMT, and that those brackets will remain what they are today. Here one would use the AMT tax table above.
The third is to forecast what the tax brackets will be if the Democrats succeed in raising our taxes. While it is of course impossible to predict what might ultimately come out of Washington, as a starter here are projected brackets prepared by the Tax Foundation, a Washington-based tax "think tank," under what it calls a "full expiration" scenario:
Up to $57,650 15%
Excess up to $139,350 28%
Excess up to $212,300 31%
Excess up to $379,150 36%
Over $379,150 39.6%
For reference, other scenarios also are presented on the Tax Foundation’s web site.
State income taxes
In addition to the core tax bracket analysis using Federal tax rates, consideration also must be given to state income taxes. A state income tax rate of 6 percent would mean another $6,000 in taxes in the above example. The two things to consider here are: 1) the effect of state income taxes on one’s Alternative Minimum Tax (high state taxes are the most common problem for AMT payers), and; 2) the possibility that retirement could involve relocating to a state with no income tax (Florida, for example). Either or both of these would have a significant impact on a conversion analysis.
Summary
Roth conversions can make sense in situations where the taxes paid today are less than what they otherwise would be at retirement. As with all tax planning, no generalizations can be made. Everyone’s situation is different, so one has to take a big gulp and make a best guess on the future tax bracket that will apply. Also, an online calculator is a must, especially when doing AMT planning.
