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Introduction

Roth IRA’s were first established under the Taxpayer Relief Act of 1997 which added I.R.C. §408A to the Internal Revenue Code as a new retirement savings vehicle.  Unlike traditional Individual Retirement Accounts (“IRAs”), distributions from which are subject to ordinary income tax, certain “Qualifying Distributions” received from Roth IRAs are tax-free.  In addition to making annual regular contributions to Roth IRAs, individuals may also make qualified rollover contributions, including conversions of traditional IRAs to Roth IRAs.

Under the Tax Increase Prevention and Reconciliation Act of 2005, conversions of traditional IRAs to Roth IRAs in 2010 and beyond are no longer subject to the Adjusted Gross Income (“AGI”) threshold which applied up until 2009.  Thus, certain individuals who otherwise never qualified to convert a traditional IRA to a Roth IRA will be eligible beginning in 2010.  The purpose of this outline is to discuss the rules applicable to the conversion and the factors which must be considered in making the determination whether the conversion will be beneficial to the individual.

Unfortunately, there is no single factor or formula that can be utilized to determine whether conversion from a traditional IRA to a Roth IRA makes sense for an individual.  Rather, there are a myriad of factors that must be considered.  In addition to there being a myriad of factor, the analysis depends on the individual’s assumptions for not only rates of return but also for future tax rates and earning power of the individual.  Thus, each of the below listed factors must be analyzed in the context of each individual’s assumptions and willingness to assume certain risks.  The factors to be considered are 1) the individual’s ability to pay the conversion income taxes from non-IRA sources, 2) the individual’s current and future income tax rates, 3) the lifetime spending intentions of the retirement assets, 4) who will be the ultimate beneficiaries of the retirement plan assets and 5) whether or not the individual’s estate will be subject to federal or state estate and inheritance taxes.

Ability to Pay Conversion Income Taxes from Non-IRA Sources

Although all factors must be considered, the single most important factor is the individual’s ability to pay the income taxes due as a result of the conversion from assets outside of the assets that are being converted.  The reason is that by paying the taxes with outside assets the individual is able to obtain tax-free growth on the assets, the growth on which would otherwise be subject to income taxes.  Tax-free compounding will always equal or exceed tax-deferred compounding.

To the extent that an individual can afford to take assets outside of the converted assets to pay the income tax, the conversion allows the individual to contribute more dollars to the Roth IRA, thus allowing more money to benefit from the tax-free growth.  Further, the longer the time horizon that the assets can remain growing in the tax-free environment provided by the Roth IRA, the more advantageous the conversion will be to the individual.

Current v. Future Income Tax Rates

An individual who is considering converting a traditional IRA or retirement plan to a Roth IRA must consider the individual’s current tax rate as compared to the individual’s anticipated future tax rates at the time the money will be withdrawn from the account.  Assuming a constant tax rate during periods of accumulation and distribution, one would think an individual would be indifferent to the conversion.  However, as demonstrated above a simple analysis which considers only current and expected income tax rates is flawed.  One of the main benefits of the Roth IRA is not only the tax-free distribution of assets but also the tax-free accumulation of the assets once they are placed in the Roth IRA.  Thus, even assuming constant rates, since the Roth earns tax-free income on funds which would otherwise be held outside of tax deferred accounts and will generate taxable income, the Roth account will always at least equal or exceed the value of the after-tax account.

Lifetime Spending of Retirement Plan Assets

The above factors all highlight the benefit of a longer period of deferral for the assets contained in the Roth IRA.  Therefore, an individual must take into consideration lifetime spending of the retirement plan assets.  Specifically, the individual must consider whether the assets held in the retirement plan will, in fact, be used to provide an income stream to the individual during his or her retirement.  The depletion of the Roth IRA assets while the individual is alive, will require the analysis to consider more heavily the individual’s ability to pay the conversion taxes from outside assets and current and expected income tax rates during the periods of withdrawal.  This is because the funds held in the Roth IRA may have a significantly shorter period of time to accumulate tax-free earnings.  Further, to the extent that certain traditional IRA assets will not be required to fund expenses during retirement and the individual would only otherwise take his or her required minimum distributions, this will favor a conversion of those assets not needed to fund retirement expenses to a Roth IRA.

Who are the Beneficiaries?

In determining periods of withdrawal in the analysis, it is also important to consider the needs of the ultimate beneficiaries of the retirement plan assets upon the death of the account owner.  If it is expected that the beneficiary, whether it be the spouse, child or grandchild, would expend or receive the funds immediately after death of the account owner, the benefit of the tax deferred growth is significantly diminished making the conversion less attractive to the individual.  On the other hand, if younger beneficiaries are named beneficiaries of the converted Roth IRA accounts, the longer period of growth will add substantial benefits to the extent the beneficiary takes distributions over his or her extended life expectancy.  There is no better asset for a beneficiary to inherit than a Roth IRA.  This is a direct result of the fact that distributions are not subject to income tax and the money can continue to grow tax-free.  Conversely, if the individual is naming charitable beneficiaries as the beneficiaries of his or her retirement plan account, conversion would not make sense as the account will ultimately be distributed tax-free to the charity upon the death of the individual.

Estate Taxes

Individuals who have estates that are subject to federal and state estate or inheritance taxes can achieve significant estate tax savings through the conversion of a traditional IRA to a Roth IRA.  The additional savings stems from the fact that the income tax paid on the conversion will be completely removed from the individual’s estate.  If the individual had not completed the conversion, the full value of the traditional IRA is included in his or her estate.  Thus, the distributions taken by beneficiaries will be subject not only to income tax, but the value of the account would have also been subject to estate tax at the time of the individual’s death.  Although there is an income tax deduction for estate taxes attributable to the inherited items on the beneficiary’s tax return as income in respect of a decedent, the deduction is subject to limitations as a miscellaneous itemized deduction that is not subject to the 2% floor, which results in the beneficiary not achieving the entire benefit of the deduction.  Thus, a taxable estate can be significantly reduced by accelerating and paying the income taxes allowing the beneficiary to receive the converted assets tax free over his or her life expectancy after the individual’s death.  The savings can be significant, especially when the taxable estate is reduced so that the estate is no longer subject to estate taxes.