While many people have been touting the benefits of Roth IRA conversions, the odds are, many retired investors will be better off if they don’t convert.
In general, for a conversion to make sense, clients need to be confident that they will be subject to higher income taxes in the future, they need a source of funds to pay the conversion taxes that aren’t also subject to tax, and they need to be able to bear the risk of a market downturn at the time of conversion. As a result, retired clients have a high hurdle before they proceed with a conversion.
Federal tax rates
Early this year, most people seemed convinced that we would have a Democrat in the White House and that we would see higher income tax rates over the next few years, leading them to think there was good reason to pay taxes right away.
Now it isn’t clear who will be our next president. Moreover, although Barack Obama has been talking about tax increases, he recently indicated that he may not push for higher taxes if the economy is still struggling.
Don’t simply assume that a Democrat means higher taxes and a Republican means lower taxes. The bottom line is that one cannot predict future tax rates with any degree of certainty. Any analysis about future tax rates should be discounted because we are all just guessing.
Personal tax rate
Even if some income tax rates increase, the tax rate your client pays on their individual retirement account distributions may not. For instance, Mr. Obama has proposed eliminating income taxes for seniors making up to $50,000 a year. While $50,000 may sound like a low threshold, at a 5% distribution rate, that is a $1 million IRA. If some form of that provision were to be implemented, a client may find that his tax bracket is 0% for a portion of their future IRA distributions. Converting today at even a 15% tax rate might not turn out to be a good idea.
Alternatively, future tax rates may go up, but the tax bracket for your client may not. Let’s assume that the 35% bracket goes to 39%. If your client is in either the 25% or 28% bracket, however, there may be no change to their tax rate (those brackets cover joint income up to about $195,000). There is even a possibility that “middle income” Americans may see an income tax reduction, regardless of who is in the White House.
Source of funding
Assuming you are confident that your client’s IRA distributions will be subject to higher taxes, a conversion may make sense only if the client has a “clean” source of funding to pay the taxes on the conversion. A clean source is a pool of assets outside the IRA that also would not be subject to additional taxes if used to pay the tax on the IRA. If you don’t have a clean source of funds, then the cost of conversion goes up.
Assume that your client converts a $500,000 IRA and owes $150,000 in taxes on the conversion. Also assume they have $150,000 in taxable investments with a cost basis of $100,000 and are subject to 20% tax on the gains. If the client sells the $150,000 in assets to pay the conversion tax, they owe another $10,000 in taxes, which makes the conversion more expensive.
Alternatively, the client could use the funds in the IRA to pay the tax, but that means the client has $150,000 less that will go into the Roth IRA, which defeats the main purpose of making the conversion.
Market risk
Let’s assume that your client converts the IRA and pays 30% in taxes on the conversion. They have lost 30% of their capital to pay taxes they didn’t currently owe. Now consider what happens if the client experiences a 20% bear market shortly after the conversion. While technically, the tax doesn’t go up, the cost to the client may appear to be a lot more than they bargained for.
With all of these unknowns, many retirees in the middle income tax brackets may be better off not converting.
So does it ever make sense for a retiree to convert to a Roth IRA? Yes. A Roth conversion (or partial conversion) can be a good tool for retirement and estate planning under the following conditions: the client is highly likely to be in a higher income tax bracket in the future, the client does not need the converted IRA assets for basic living expenses, and they have a clean source of funds to pay the taxes.
For these clients, a conversion will create a tax-free source of funds that is not subject to the required minimum distribution rules. Tax-free distributions from the Roth can be used to enhance the clients other sources of taxable income. Moreover, the assets can pass to the client’s children free of income taxes and may grow tax-free for decades.
Because each client’s circumstances are unique, before converting to a Roth IRA, make sure you consider all the variables.
