Money Matters

Many issues to consider when converting IRA to a Roth

December 8, 2012 

Q. I have a relatively small IRA, $200,000. We’ve put most of our spare change in real estate and have several rental properties that generate a nice income. I’ll be 70-1/2 in five years, so my required distributions will begin at that time. I’ve been reading that one should consider converting an IRA this year if one has the money outside of the IRA to cover the tax hit from the pending tax rate increases for people in the top brackets.

We have the money, but I hate the idea of giving it to Uncle Sam earlier than necessary. We have taken a lot of risks to get where we are financially, had years of being in a fairly low tax bracket, put four kids through college, and now in retirement almost half of our income goes to pay income taxes. Do you think it makes sense to convert and pay taxes now, or wait and pay tax on required distributions?

Everyone’s situation is different, so the answer to your question will vary from person to person.

One of the forgiving rules about Roth IRA conversions is the ability to recharacterize (undo) the conversion back to an IRA. If you convert an IRA this year, you will have until Oct. 15, 2013, to initiate and complete a recharacterization. It would be best to know whether a conversion makes sense for your situation and leave a sharp decline in market value as the only reason to recharacterize next year.

There are a lot of issues to consider when you are deciding whether to convert or not to convert an IRA to a Roth. Estate tax planning, current and future income tax rates for you and your heirs, the impact of present and future income on the taxation of Social Security Benefits, and Medicare premium costs are a few.

There may be other ways to address these issues, such as gifting cash, appreciated stock, income generating investments, or even contributing to a 529 plan. That is why a meeting with a knowledgeable financial planner or tax professional is advisable.

With that said, it may be of interest to run a simple comparison from a pure numbers standpoint. Since I don’t know your overall financial situation, I will need to make several assumptions for this comparison. We’ll assume you are in the highest tax bracket now and in the highest proposed for 2013 and beyond. It usually makes sense to convert only if you have the money to pay the taxes owed outside of the IRA, so we will assume you will pay any tax owed from an after-tax account. Assume a 6 percent after-tax rate of return.

Option 1: You convert $200,000 this year; you will owe $86,000 in federal and state income tax (35 percent federal plus 8 percent state). In five years, the value of your Roth IRA will be $267,645. There is no required minimum distribution from a Roth IRA, but for comparison purposes, assume you would make withdrawals equal to the amount of your RMD. At 70-1/2, the RMD withdrawal factor is 27.4, so the distribution amount would be $9,768. From the Roth IRA, no tax is owed on the distribution.

If the same RMD came from a traditional IRA and you remain in the highest tax bracket due to other income sources, the money would be subject to federal (assumed 39.6 percent top federal rate after 2012) and state (assume 8 percent) income tax, and if it applies, the proposed 3.8 percent additional tax on investment income for a total of 51.4 percent. After tax, you would have only $4,747.25 to spend.

Option 2: You don’t convert, and you don’t pay $86,000 in taxes this year. You earn only 2.92 percent in your after-tax account because we will assume the highest tax bracket applies and your 6 percent rate of return is reduced by 51.40 percent. In five years, the $86,000 is worth $99,292 after taxes. To make up for the $5,021 that you have to pay in taxes on the RMD, you use money from this account either to pay the tax or to meet other expenses. $99,292 invested at 2.92 percent after taxes will generate $5,021 for 30 years.

Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 99466, Raleigh, NC 27624

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