Sign-up now to receive notification on new content

The Money Guy Show | Investing, Tax, Estate, Retirement, Insurance, Spending, Saving, and Wealth Building Advice

Going beyond common sense and helping you make smart financial decisions.

/

Roth Conversion: In-Depth Analysis

Money-Guy 01-28-2010

Well here it is; we finally did it. You have been writing, calling, and asking for us to explain and go through the nuts and bolts of the Roth conversion and why 2010 is such an important year. You can’t really turn on any financial media or read any financial literature and not come across something that at least mentions or alludes to the this planning opportunity.

So what is so different about the year 2010? Well, there are actually two big differences:

  1. Anyone can do it no matter what their income.
  2. The taxes resulting from a Roth conversion made in 2010 can be deferred over the following two years (2011 and 2012).

Why would you want to have money in a Roth IRA? With a Roth, contributions are made with after-tax money. Simply put, there is no immediate tax benefit from putting money into a Roth IRA. However, that money is allowed to grow tax-free and withdrawals in retirement are tax-free as well assuming certain conditions are met. Not only this, but there are also no Required Minimum Distributions associated with Roth IRAs when you reach age 70 and a half.

As you listen to the show, I will walk through the ins and outs of the process, who it makes sense for, and also who it does not make sense for. As a summary, if any of the following describe you, then you may be a good candidate for the conversion:

  • You can convert at low or no cost
  • Your taxable income is likely to be higher in retirement
  • You anticipate higher tax rates during your withdrawal period
  • You can defer Roth balances past when Required Minimum Distributions are scheduled to begin
  • You seek to potentially maximize after-tax dollars passed to heirs
  • You have outside cash to pay any additional taxes.

I also explain our analysis on how we make the determination for our wealth management clients of whether to convert or not, and, if so, how much they should convert. Hopefully as you listen, you will recognize the questions you should ask and the thoughts you should have to determine if this is a planning opportunity you should take advantage of.

You will also hear me share some listener emails in the show today. This show is produced for you, the listeners, and you have no idea how much we value your comments and feedback! Please keep them coming so that we can provide you with the content you want to hear.

Reader Interactions

Comments

  1. Hey Brian (and Bo),

    LOVE this show. I had to do so much homework on my own, before the podcast, to figure out what you had in this compact and wonderful 55 minute podcast. Bravo on all the hard and clear work. Just a couple of comments.

    1) I too have post-tax IRA(s) and thought I was home free! HA HA! We have a rollover IRA from my previous employer. So because I cannot cherry pick my IRA(s) to convert, I looked into the options at work, and guess what – they allow us to roll my existing (ROLLOVER IRA ONLY) IRA into our 401k at work! So once I do that I will be left with JUST my non-deductible IRA and now the cost of the conversion is way low. So please check with your employeer if that is an option!

    2) To double check the calculation – check out this guys website, it is nice and clear, and gives great examples. http://www.goodfinancialcents.com/2010-traditional-ira-to-roth-ira-conversion-tax-rules/ and http://www.goodfinancialcents.com/2010-roth-ira-conversion-rules.

  2. Brian,

    Enjoyed the show on Roth Conversions. I wanted to point out one area I think you neglected. I have a 401k which held after tax contributions. I checked with my company’s plan and they allowed me to separate the after tax contribution portions and convert to a Roth. I’m fortunate in that the pre-tax and after tax contributions were separate. Since, I hadn’t had any return on the after tax amt, I was able to convert $25k into a Roth at Vanguard tax free. So, now going forward – all growth will be tax free.

    Anyway, great show. I really enjoy it.

    Mike/Colorado

  3. Two things I’m not clear on are —
    1) If the payment of taxes on a 2010 conversion are split between tax years 2010 and 2011, must the split be 50/50? and
    2) will the payment made for 2011 be based on the tax rates in effect for 2011?

    (I suspect the answers are “yes” and “yes.”)

  4. Brian, thank you for the great pod-cast and Roth conversion analysis. One thing that still confused me however (after listening and re-listening) is this. The IRA’s are separate to each spouse and presumably each spouse is the designated beneficiary of the other. When you look individually at each IRA under consideration for conversion, as I understand your analysis, you must then consider and thus combine the deferred holdings of the counter-party (spouse), assess the basis in the aggregate in order to determine the amount that will be attributable to tax – correct? So for example, if I had an $80K non-deductable IRA, and a $600K rollover SEP from a 403(b) and my spouse had a 403(b) (not a factor for consideration) and a $20K non-deductable IRA, we would have to consider my $680K combined with her $20K for a total of $ 700K to determine the potential taxable basis to convert only her $20K?

    Thank you

  5. Brian,

    I thoroughly enjoyed listening to your Roth conversion podcast this morning and admire your willingness to take on such a complex decision as conversion and try to boil it down to finite scenarios. I’ve been wrestling with this for my clients.

    I wonder if, in your analysis, you’ve had as much difficulty integrating the Alternative Minimum Tax as I have in developing guidelines. Putting aside the fact that it will require an act of congress (literally) to index the 2010 AMT exclusion to be in line with 2009, if I assume an indexed 2010 AMT, $3,000 real estate taxes (typical for my clients), and a 6% marginal Missouri income tax, I have eight marginal tax brackets for married filers in 2010 to compare to unknown, future rates!

    Also, if I use the tax rates as they stand today (Bush tax cuts expiring in 2011 and tax rates going up a minimum of 3%), I have yet to see a client who is better off spreading the taxes over the (higher) 2011 & 2012 tax years if they expect a comparable income in those years. Has this been your experience? For those with large balances to convert, spreading the income over multiple years may push some of the dollars into a lower bracket, but as the $100,000 limit is not coming back, this can be achieved with partial conversions ‘filling up’ the client’s marginal tax bracket year after year.

    Again, most of what I’ve seen & heard has been written by journalists rather than practitioners so it was great to hear your point of view. Keep up the good work. I look forward to every podcast.

    Sincerely,

    John Dutemple, CFA, FSA
    President

    Compton Advisors, LLC – Planning Futures, Managing Wealth

  6. Robert,

    Great question! One of the really great things about this Roth conversion is that you actually DON’T have to aggregate IRA balances between spouses. Each spouse must file their own IRS Form 8606 (unless the form changes in 2010). As I currently understand the conversion, in your example you would have $80k basis with total IRA balances of $680k. This means that about 88% of the amount you convert would be taxable. Your wife, however, would have total IRA balances of $20k with a $20k basis. Therefore, she would be able to convert all $20k without creating a taxable event.

    Thanks for the question and I hope this clear things up!

  7. John,

    The AMT has not been much of an issue in our conversion calculations. AMT essentially makes you take your after-deduction income and add back certain deductions (taxes, misc. itemized, etc.). Then, once you get this new income number (the AMT taxable income), you have to multiply it by either a flat 26% or 28% depending on your level of income (essentially a flat tax). Realistically, the types of individuals whom we have seen the conversion make the most sense for are those who fall in the 15% – 25% brackets (not hit by AMT) or high earners that have passed the AMT threshold. While I’m sure there are individuals and situations where this problem could occur, I would image the other screens we suggested (outside funds to pay the additional taxes, high relative basis in total IRAs, ability to leave balance for at least 5 years, etc.) would help to avoid having to analyze the AMT implications. As for spreading the taxes, we recommend maxing out the 15% or 25% brackets in the current year. Without knowing for sure the future of tax rates (2011 and 2012), it is difficult to say definitively when will be the most advantageous time to pay the taxes. As we learn more, and Congress releases more information, it will be easier to make these decisions.

    I hope this helps!

  8. Hey Brian,

    I have one follow-up question. Is this Roth IRA conversion loophole, a onetime loosening of the rules for 2010? Or have the Roth IRA conversion minimums been removed for all years going forward?

  9. David,

    As it stands right now, the $100k income limit for doing a Roth Conversion is not coming back. However, I am hard-pressed to believe that it will stay this way indefinitely. The one-time opportunity associated with 2010 is the ability to spread the tax liability over two years.

  10. Hey Brian – this is a HUGE win for the higher bracket folks, which in CA is like – everyone, as you cannot survive out here without two job families. Anyway, if it is true that the ROTH conversion limit is all but gone for now, why do they still have a cap on ROTH contributions, everyone is going to just put the money into a non-deductible IRA and OH -wait – convert it!

    Use this year to manage the IRA(s) you have and move them back to the workforce and leave just the after tax IRA. Convert that this year and pay the tax for the next two years (for gains or such), and then going forward never pay for ANY further ROTH contributions (through a conversion). Paperwork yes, savaings HUGE!

    THANKS!
    David

  12. Brian,

    Yes, the Roth podcast can be downloaded to your iPod. If you go to iTunes, we are on the Featured Business Podcast page. You can also search by name, Brian Preston. If you choose to subscribe in iTunes (free), you can have every new show automatically downloaded as soon as we release it. I hope this helps!