Financial Fitness: Assessing the Value of the Roth IRA Conversion

The interplay among an intricate web of factors determines the strategy’s potential value

A Roth IRA, in its basic form, is a tax-advantaged retirement savings vehicle for individuals and couples with incomes below a certain threshold. Those at the higher end of the income spectrum can also gain access via Roth IRA conversions, which can offer some wealth accumulation and estate planning benefits. The extent of these benefits can be tricky to evaluate, however, so a detailed analysis is warranted to determine whether the strategy is a good fit for your situation.

In a Roth IRA conversion, you move assets from a traditional IRA (or employer-sponsored retirement account) to a Roth IRA via a distribution, which triggers an income-tax liability on pretax contributions as well as investment earnings on pre- and post-tax contributions to the original account. While income limits exist for contributions to Roth IRAs, individuals of all income levels can perform a conversion.

Why Convert from a Traditional IRA to a Roth IRA?¹

In the decades since the Employee Retirement Income Security Act of 1974, as amended “ERISA”, came into being, we’ve been incentivized to defer taxes for as long as possible through savings vehicles such as IRAs and 401(k)s. The immediate tax liability triggered by a Roth IRA conversion begs the question, why would anyone choose to pay taxes ahead of schedule? While counterintuitive, there are compelling reasons that you might choose to perform a Roth IRA conversion:

1. No required minimum distributions (RMDs). Traditional IRAs require that you start taking RMDs at age 70½. If you neither want nor need that income, converting to a Roth IRA will enable you to leave those assets in a Roth IRA account that can continue growing on a tax-exempt basis. Upon your death, your heirs will be subject to RMDs according to the rules applicable to inherited IRAs, but those distributions will also be tax-exempt.
2. Reduce the size of your taxable estate (federal and/or state). The taxes due upon conversion to a Roth IRA can be significant, so paying them will likely reduce the overall size of your taxable estate.

Conversion Candidates

The potential benefits of a Roth IRA conversion tend to be highest among a select group of people who meet certain criteria.

If you are unlikely to take distributions from your IRA and wish to pass the assets to a spouse, children or other individuals upon death, a Roth IRA conversion may be worth considering. By paying the tax upon conversion, you effectively prepay the income tax for your beneficiaries and simultaneously reduce the size of your estate. As such, Roth IRAs can confer significant tax advantages to beneficiaries while also keeping the assets accessible should you need to draw on them during your lifetime.

The ability to pay the taxes due upon conversion to a Roth IRA with funds outside the Roth IRA is another compelling factor. If you do not have sufficient outside assets and pay the taxes out of the Roth IRA, then you decrease the amount of assets that can benefit from tax-exempt growth and distribution.

It’s generally a good idea to avoid tapping into the funds in the Roth IRA for a minimum of five years following the conversion. While you can access your principal in the Roth IRA at any time, the tax-exempt status of growth and earnings kicks in after a five-year holding period.

Due to the significant tax bill that goes with a Roth IRA conversion, it makes sense to perform one when your tax bracket is lower than it might be in future years. For some, this could be the period between the start of retirement and the triggering of RMDs. However, even absent this circumstance, the conversion can still make sense. Remember that, while you pay income taxes on the conversion up front, in not having to take the RMDs later you may lower your future annual tax bill.

Other Considerations

All things being equal, and assuming your tax rate remains stable throughout your life, it should not matter whether or not you convert. You either pay taxes on “the seed” (upon conversion) or “the harvest” (when you take RMDs). It’s simply a question of the timing of the payment of taxes. However, there are other factors to consider.

Putting aside for a moment the variability of your effective tax rate from one year to the next, the difference between converting and not converting plays out in the gradual erosion of your taxable side account—the one that would be depleted to pay the tax upon conversion. When you perform a conversion and pay the resulting tax with assets from a taxable account, the full value of the retirement assets remains in the Roth IRA to grow tax-exempt. Conversely, if you do not perform the conversion, the amount you would have withdrawn from the taxable account remains in that account, where it continues to grow but will be subject to taxes on interest and dividends (and perhaps capital gains) each year. All things being equal, and assuming the assets were invested in a comparable allocation in both scenarios, you might expect the value of the Roth IRA in the distant future to be higher than the sum of the after-tax value of the traditional IRA and the taxable side account.

If you have a federally taxable estate that includes traditional IRA assets, there is an additional consideration: Your heirs may be entitled to an IRD tax deduction. The IRD deduction is an attempt to account for the fact that, otherwise, your heirs would pay income taxes on assets that have already been assessed with the estate tax—which may be thought of as a form of double taxation. The deduction does not apply to beneficiaries inheriting a Roth IRA from a decedent with a taxable estate, as the Roth IRA income is not taxable upon distribution.

If you have inherited an IRA that may be eligible for the IRD tax deduction, consult with your tax accountant or the trust and estate attorney who handled the estate. In the event that you are eligible for the IRD deduction, you would need to remember to claim it each year on your tax return.

Timing the Conversion

You may convert the entire IRA in one year, or spread the conversion over multiple years. A detailed examination of the advantages and disadvantages of each approach can be performed with your financial advisor or tax professional. The analysis should not focus exclusively on the regular federal marginal tax brackets, but should also take into account the potential impact of the alternative minimum tax.

If you convert to a Roth IRA and then the value of the account declines substantially, you have the option to “re-characterize” your Roth IRA back to a traditional IRA. You would receive a refund on the tax paid on the conversion and, if you chose, could reconvert to a Roth IRA with a potentially lower tax liability based on the reduced value of the account.²

The success of a Roth IRA conversion will depend on a complex interplay of myriad factors including current and future tax rates, income requirements, investment performance, longevity and personal financial goals. For many people, the difference may be small or nonexistent. In some cases, the conversion could result in a loss—for example, if you need to withdraw assets soon after the conversion or your future tax rate drops sharply. Generally, the conversion tends to be most compelling when considered from the perspective of estate planning. Working with a financial advisor to assess your situation and the potential outcomes of a Roth IRA conversion can help you determine whether it is a feasible option for you.

IRS Circular 230 Disclosure: Please be advised that any discussion of U.S. tax matters contained within this communication (including any attachments) is not intended or written to be used and cannot be used for the purpose of (i) avoiding U.S. tax-related penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.