I am currently knee-deep into my final client Roth IRA conversion analyses before the year ends and since I am doing that, I thought I would share some ideas that are going through my head as I do this.
First off, in order to consider this, it is likely that you think that tax rates will be much higher in the future than they are today. It’s not necessary to believe this to make a Roth conversion sound good, but it sure as heck boosts the argument for it!
Second, you should likely have a decent amount of liquid (i.e. easily reachable) cash savings available on top of your retirement accounts and emergency funds to pay the conversion tax without financial strain. Third, it is helpful if you have strong reasons to convert – for example, you’re in a high tax bracket or you’re approaching age 70 1/2 and do not plan to use your IRA and therefore, you want to leave the maximum amount to your heirs (a stretched out Roth could be a very powerful asset).
With all of this said, what I am considering are items like the above, in addition to what is the IRA money used for, when will it be needed, what is the client’s tax rate, and how much room is available at the current tax rate. The last one is important because there better be a darn good reason to push someone into the next higher tax bracket with a conversion tax if they would likely never get there had they maintained their current course. In this case, perhaps a partial conversion would make sense (yes you can do that).
Roth conversion planning is especially important now with such developments as the expiration of the 2001/2003 tax code changes (rates are moving higher automatically unless Congress does something this year), the health care tax of 3.8% kicking in in 2013 that hits INVESTMENT INCOME (including passive real estate rental income) but excludes IRA’s, and the tendency for those with large IRA’s to leave the money to heirs which will soon be exposed to much higher estate tax liability.
One side note that Ed Slott, well-known IRA expert points out, is that in the future, Roth conversions could push AGI (adjusted gross income) high enough to expose investment income to the health care tax. He also cautions those considering using IRA trusts to consider a Roth IRA as the funding vehicle and keeping the IRA in the deceased person’s name and filtering only the RMD’s (required minimum distributions) through the trust (Roth has RMD’s for non-spouse beneficiaries but not for original owner or spouse).
Bottom line – it comes down to math and your personal planning concerns. If you are considering a Roth conversion, consult a diligent number-crunching CPA or financial planner (or a good team of experts that includes both like we do) to consider the financial and planning implications side by side. What is the difference between a financial and a planning implication? For example, some decisions, may not make sense on their face financially, but if future plans include significant investment income (such as rental income) then perhaps paying taxes now might make sense. On the other hand, someone may abhor paying taxes and love the idea of a tax-free Roth IRA, but if that person is in the 15% tax bracket, and likely to stay there, then dislike of taxes should not trump common sense. The planning team should work a spreadsheet and decide if it could make sense mathematically and if there is enough spare cash to pay the extra tax.
What I would recommend not doing = winging it! Feel free to drop a question by email or phone.