Roth IRA conversions: Switch now to avoid higher taxes

October 29, 2010

If you’ve been thinking of converting some of your retirement assets to a Roth IRA, rising tax rates are just one more reason to do it sooner rather than waiting till next year.

With a traditional IRA you pay taxes when you withdraw money, but with a Roth you pay those taxes when the money goes in. For those who think taxes will go up, and especially for those who expect to have substantial assets to pass on to the next generation, a Roth is a nice planning tool. That’s why when Roth conversions were opened up to those with modified adjusted gross income greater than $100,000 in 2010, financial planners and private wealth advisers urged many of their clients to make the switch.

For those who’ve been loath to go Roth — after all, who wants to pay taxes in advance? — the possibility of higher tax rates in 2011, especially for high-income taxpayers, provides a new impetus to convert before year end. “Do it now instead of waiting,” says Craig Richards, director of tax services at Fiduciary Trust. “Tax rates are not going to be any cheaper on the conversion than they are now.”

There are some general rules to keep in mind — and some situations in which you won’t want to convert to a Roth. If you need to tap your tax-deferred retirement savings to pay the tax bill, don’t do it. Ditto, if you think your own income tax rate will go down a lot, perhaps because you are a high net-worth New York City resident who plans to move to Florida next year to retire.

Who benefits the most from a Roth conversion? People who have substantial retirement assets that they do not need to touch for awhile, if at all. “It is not necessarily the age of the investor that is important, but the time frame in which the money is likely to be consumed,” says Patrick Boyle, a director at Bernstein Global Wealth Management.

A 50-year-old who plans to burn through his retirement assets at age 60 has a relatively short time horizon, while a 70-year-old who doesn’t need her assets and plans to pass them on to a younger beneficiary could have a much longer one.

The really big payoffs come to those who leave assets to their kids or grandkids, as the inheritors will never owe income tax on the Roth. For those worried about the estate tax, a Roth conversion is an interesting planning tool since those tax payments lower the value of your future estate (though Roth assets are still included in the estate’s value).

“What is interesting is that when you run the numbers for Roth conversions in the presence of the estate tax, it tilts the odds further in favor of the Roth,” Boyle says.

By Bernstein’s calculations, the median advantage of converting a $1 million IRA to a Roth and passing it on to 35-year-old beneficiary who keeps it for a 20-year stretch is $283,000 in the absence of an estate tax, but $514,000 factoring in a federal estate tax. Says Boyle: “If you like the Roth without the estate tax, it’s even a little better option with the estate tax.”

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