Q. What is a Roth IRA conversion?
A. A Roth IRA conversion is simply a tax strategy under which the tax status of an IRA changes from a Traditional IRA to a Roth IRA. Under the right circumstances, a Roth conversion can provide significant income and/or estate tax savings. Prior to 2010, this option existed only for taxpayers with less than $100,000 in adjusted growth income (AGI). This income limitation has been eliminated, and now anyone, regardless of income, is eligible to convert a Traditional IRA to a Roth IRA.
Q. What are the advantages of a Roth IRA conversion?
A. A Roth IRA provides two major advantages over a Traditional IRA. First, all distributions from a Roth IRA (generally after a 5-year holding period and reaching age 59 ½) are tax-free, while distributions from a Traditional IRA are taxed as ordinary income. If you own a Roth IRA and die, the distributions continue to be tax-free for your beneficiaries. Second, as an owner of a Roth IRA, you and your spouse beneficiary are not subject to the Required Minimum Distribution Rules that apply to a Traditional IRA. (Required Minimum Distributions are required if your Roth IRA is inherited by a non-spouse beneficiary, but these distributions can be spread over the life expectancy of the beneficiary). So, by converting a Traditional IRA to a Roth IRA, you exchange tax-deferred growth for tax-free growth, exchange taxable withdrawals to tax-free withdrawals, and eliminate any requirement that assets be removed from the IRA during your or your spouse’s lifetime.
Q. What’s the catch?
A. Of course, there’s always a catch. You must pay taxes (at ordinary income rates) on any amounts converted from a Traditional to a Roth IRA in the year of conversion. Essentially, the owner is treated as if he or she
withdrew the assets from the Traditional IRA and re-contributed the assets to the Roth IRA.
Q. Why do I want to pay taxes sooner than I have to?
A. As financial advisors, we normally try to find ways for our clients to defer taxes, not pre-pay them. So why are we now talking to you about a strategy that does exactly the opposite? Because of the special tax and estate planning advantages offered by Roth IRAs, we believe that some clients can reap significant long-term savings and estate planning advantages from converting and paying taxes sooner rather than later. While we think that anyone who owns a Traditional IRA (and even some who do not currently have an IRA, as discussed below) should review their options, the conversion opportunity offers significant potential savings in the following circumstances:
- You do not need to draw on IRA assets for cash flow;
- You have a relatively long period before drawing on IRA assets for cash flow;
- You can afford to pay the taxes on the amount converted out of non-IRA assets;
- You expect your tax rate at the time of expected withdrawal to be higher than your current rate; or
- You want to leave IRA assets to the next generation free of income tax burdens.
If you expect to draw on the IRA for cash flow in the future, the key is tax rates. Conversion probably makes sense if you expect your tax rates to be higher at the time of the withdrawal than at the time of conversion, and probably does not make sense if you expect your tax rates to be lower at the time of the withdrawal than at the time of conversion.
Q. Do I have to convert all of my IRA assets to take advantage of this opportunity?
A. No, you can convert any amount you want. For example, if you are not subject to the highest marginal rates, you can determine how much you can convert without pushing yourself into the next tax bracket.
Q. I’m interested, but what happens if my IRA drops in value after I convert? Haven’t I paid too much tax?
A. Let’s say you convert $50,000 of Traditional IRA assets on January 2 and find that the account is worth $40,000 on June 1. It looks like you may have paid too much in taxes, since your tax bill would have been lower if you had waited and converted on June 1. The good news is you have a “do-over” called a “recharacterization.” If for any reason you do not like the results of your conversion, you can undo the conversion and move the assets back to a Traditional IRA as if you had never converted the assets. While the recharacterization does not recoup your market losses, it does save you the taxes you would have paid. You have until October 15 of the year following the year of the conversion to complete the recharacterization, as long as you obtain an automatic extension of your tax return for that year (even if you still file by April 15). The rules on recharacterization create some interesting strategies that involve holding different asset classes in separate Roth IRA accounts. Also, there are strategies that allow you to reconvert IRA assets that have been recharacterized, sometimes immediately. These strategies are too complex to cover in this article, but let us know if you would like to learn more.
Q. All of my retirement assets are in 401(k) Plans. Do I have an opportunity to convert these to Roth IRA assets?
A. Even if you do not have an IRA, you may be able to take advantage of this opportunity. First, under recent tax changes, Roth conversions are allowed within a 401(k) Plan. However, many plan sponsors have not yet adopted this as part of their plan. If this is the case, you could take advantage of a Roth conversion strategy if you have assets in a company-sponsored 401(k) Plan (or other qualified retirement plan) and are allowed to take a distribution from the plan. You might be allowed to take a distribution from your 401(k) Plan in one or more of the following circumstances:
- You have a 401(k) Plan from an old employer.
- You have assets in your current 401(k) Plan that were rolled over from a previous employer. Most plans
allow rollover assets to be distributed from the 401(k) Plan at any time, even while employed.
- Your current 401(k) Plan allows for in-service distributions. Many plans allow such distributions after the
employee has reached age 59-1/2.
If you are eligible to take a distribution from your qualified plan, you can roll over these assets into a Traditional IRA and then convert the Traditional IRA to a Roth IRA under the rules described above.
Q. Can Congress change the rules and make Roth IRA distributions taxable?
A. In this day, anything is possible. But if history is any guide, any change to the tax rules regarding Roth IRA assets would be on a prospective basis, and assets already in the Roth IRA would continue to be exempt. Since Roth IRA principal has already been taxed, we think it is very unlikely that Congress would subject these assets to a second tax. If anything happens, and we think this is very unlikely, the worst result would be that earnings would be subject to tax on distribution, and this is no worse than the result had the assets never been converted.
Q. What’s the bottom line?
A. Whether you would benefit from this opportunity involves some complicated analysis using assumptions about current and future tax rates, the time until IRA assets are needed for cash flow, and estate planning needs. Your Ancora Team has access to a number of sophisticated models, and can work with your tax professional to help you determine whether this interesting strategy is right for you.
Howard Essner, JD, is the General Counsel, managing director, family wealth advisor at Ancora Holdings Inc.
The mention of specific securities, types of securities and/or investment strategies in this newsletter should not be considered as an offer to sell or a solicitation to purchase any specific securities or to implement an investment strategy. Please consult with an Ancora Investment Professional on how the purchase or sale of specific securities can be implemented to meet your particular investment objectives, goals, and risk tolerances. Past performance of these types of investments is not indicative of future results and does not guarantee dividends/interest will be paid or paid at the same rate in the future. The data presented has been obtained from sources that are believed to be accurate and credible. Ancora Advisors makes no guarantee to the complete accuracy of this information. The indexes discussed are market performance indices and are not available for purchase. If you were to purchase the securities that make up these indices, your returns would be lower once fees and/or commissions are deducted. Past performance of these indices is not indicative of future results of the securities contained in these indices.
Ancora Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States. A more detailed description of the company, its management, and practices are contained in its “Firm Brochure” Form ADV, Part 2a. A copy of this form may be received by contacting the company at: 6060 Parkland Blvd, Suite 200, Cleveland, Ohio 44124, Phone: 216-825-4000, or by visiting our website www.ancora.net/adv