Q. I’m thinking about converting my 401(k) to a Roth IRA this year. I retired late last year at age 65 and have about $750,000 in my 401(k). I will receive a 5-year taxable pay-out from my company (about $40,000/year) and this plus Social Security should be adequate to meet my expenses until I’m 70 so I won’t need to tap into the Roth funds for at least 5 years. I think I have enough cash on hand to cover the taxes owed on the conversion. I figure a conversion will help lower my taxes since the Roth will not have a required minimum distribution. I’m divorced and want my daughter to inherit my IRA, and she is in a fairly high tax bracket so the Roth will also let her take tax-free distributions over her lifetime. What do you think?
A. I think you need to meet with a professional before you convert your funds to a Roth IRA. A financial or tax advisor can analyze the pros and cons based on your personal situation and help determine if a conversion makes current financial sense for you and in the future how beneficial it would be for your daughter. The following simplistic approach focusing just on federal taxes may be helpful; if you are subject to state taxes the impact of that cost must be added.
For single tax filers in 2014, the federal tax rate on taxable income over $406,750 is 39.6 percent. With your $40,000 payment from your company, Social Security and a full conversion to a Roth IRA in 2014, I estimate your federal tax bill will be over $250,000. Additional tax will be owed due to the net investment income tax at a rate of 3.8 percent on the lower of net investment income or modified adjusted gross income over $200,000 ($250,000 for those married filing jointly). It’s nice if you have this amount of cash on hand to pay the taxes owed but if you don’t convert you could invest this money rather than use it to pay taxes. Your daughter could inherit the investments with a stepped-up basis.
Example: you invest the $250,000 instead in moderate growth funds returning 6 percent after taxes and die in 20 years. Your daughter would inherit an account valued at $801,783 and her basis will be $801,783 due to the step-up upon your death. She would only owe taxes on any gain beyond $801,783 when she sells.
Let’s assume you don’t convert your 401(k), roll it to an IRA invested in funds with a 7 percent before tax rate of return. In five years, at age 70, the IRA is worth $1,051,913 and since the payments from your company have stopped, you begin to withdraw a net $40,000 from your IRA to meet expenses. You’d be in a 15 percent federal tax bracket so you’d need to withdraw a gross of $46,000 a year. If you die in at age 85, the amount remaining in your IRA would be over 1.7 million. Your daughter would inherit $1.7 million + $801,783 = $2,501,783.
If you convert to a Roth and begin taking $40,000 a year out to meet expenses at age 70 and die at age 85, the remaining amount in your Roth IRA will be around 1.9 million.
If your daughter is in a high tax bracket 20 years from now, inheriting a Roth IRA may be of more benefit to her than inheriting the traditional IRA and the investment account. Assume the same rates of return as above and single filer status for taxes. She can withdraw $150,000 tax free from the Roth IRA for 30 years before it’s depleted. If she takes $150,000 from the traditional IRA based on 2014 Federal Income tax rates, she will be owe approximately $35,000 in taxes each year and the IRA will be depleted in 24 years. If she pays the taxes from her inherited non-retirement account for 24 years that account value will still be over 1.4 million. If she then takes $150,000/year from this account for 6 years the remaining account value is over 1 million.
Other important things to consider are:
• What impact a large conversion will have on your future Medicare premiums. A two-year “look-back” period is used to determine your Medicare premium. If your income was too high you will pay a higher premium.
• Future changes in the tax law. Future tax rates may be higher or lower and there is some talk about eliminating the ability for non-spouse beneficiaries to “stretch” an inherited IRA over their own life expectancy. If this proposed regulation passes, inherited retirement accounts will have to be distributed within five years. Exceptions are spouses, heirs under 18 and disabled heirs.
• Converting smaller amounts over several years may be of more benefit.
As mentioned above, a consultation with a professional is advised.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624