Many older Americans are relying on withdrawals from their
individual retirement accounts to cover living expenses. But
some seniors who don't want or need to dip into the mutual
funds and other securities in their IRAs now have a new
opportunity to leave bigger IRA nest eggs to their heirs.
Under a tax-law change that went into effect on Saturday,
more people past age 70 1/2, the age at which people are
generally required to begin taking annual distributions from
traditional IRAs, have the option to convert their existing
IRAs to Roth IRAs. That can be attractive because Roth
holders aren't required to pull money out in their lifetimes
and any withdrawals by Roth holders or their heirs are
generally tax-free.
Making the switch to a Roth can be "a great way to provide
an income-tax-free legacy for your children -- or
grandchildren, even," says Ed Slott, a Rockville Centre,
N.Y., accountant who specializes in IRAs. In contrast, with
a traditional IRA funded with tax-deductible contributions,
money withdrawn by the IRA holder or an heir is generally
taxed at ordinary income rates.
Still, there is a steep cost to convert from a traditional
IRA to a Roth: You owe tax at ordinary income rates on the
money that is moved. (There's an adjustment for any
after-tax or nondeductible contributions to the old IRA.)
Even though "normal tax planning is to postpone paying taxes
as long as possible," paying the tax bill sooner to convert
to a Roth can really pay off, says Kaye Thomas, a tax
attorney and tax-guide publisher in Lisle, Ill.
This month's tax-law change concerns an income test for Roth
conversions. As in the past, people can make the switch only
in a year when their modified adjusted gross income -- not
including income generated by the conversion itself --
doesn't exceed $100,000. But now, required minimum
distributions from traditional IRAs no longer count toward
that figure.
That means that a single person who collects $50,000 in
required IRA distributions and has another $60,000 in
taxable income would be able to convert, while previously he
or she couldn't. The cap is also $100,000 for a married
couple filing jointly. (Married people filing separately
can't do a Roth conversion.)
Tax specialists say a later-in-life Roth conversion
primarily makes sense for someone who has money outside the
IRA to pay the upfront tax bill and who also wants to
maximize IRA dollars to be left to heirs.
Making the switch pays off in two primary ways: By avoiding
future mandatory distributions, more money keeps growing
longer under the tax-favored IRA umbrella. Also, paying the
conversion tax bill from money outside the IRA "in a sort of
a hidden way increases the size of your retirement savings,"
says Mr. Thomas, whose Fairmark.com Web site offers
extensive Roth IRA guidance.
Look at it this way: If you assume a 30 percent tax rate,
$100,000 in a traditional IRA funded with pretax (that is,
deductible) contributions is worth $70,000 after tax. But
doing a Roth conversion and paying the tax from assets
outside the IRA leaves you with a Roth IRA worth the full
$100,000, since Roth withdrawals are generally tax-free.
The advantage of passing money to heirs in a traditional or
Roth IRA is that the money can continue to grow tax-deferred
or tax-free for many years. A spouse who is named as an IRA
beneficiary can simply merge the inherited IRA into his or
her existing IRA. Other individuals who are designated
beneficiaries are subject to different rules on pulling the
money out of an inherited IRA, but they can opt to stretch
those payments over many years based on life expectancy.
An inherited IRA can compound to particularly large sums
over time if the beneficiary is very young. A one-year-old
girl who inherits a $100,000 IRA and spreads the withdrawals
over her lifetime might be able to withdraw a total of over
$8 million, Mr. Slott notes in a new book called "Parlay
Your IRA into a Family Fortune."
One factor to consider in weighing a Roth conversion is
future tax rates -- both the general schedule of tax rates
and the particular brackets you or your heirs may be in.
If you believe the federal government is going to raise tax
rates over time, for instance, that is a reason to consider
a Roth conversion now. And converting to a Roth can be "a
big win" if you are in a low tax bracket and expect to pass
your IRA to beneficiaries whose incomes make them subject to
higher rates, says Stuart Ritter, a financial planner with
fund company T. Rowe Price Group in Baltimore. That is
because paying the tax bill at your lower rate will
ultimately produce more cash for your heirs than if you left
them a traditional IRA and they paid the tax.
But converting to a Roth may not be a good idea if you are
in a high tax bracket and you believe your beneficiaries
will generally be in lower brackets. Also, Anthony Luciano,
a vice president for retirement products at Fidelity
Investments, notes that if you are converting a large IRA to
a Roth, some of that conversion income could end up being
taxed at higher than your usual tax rate.
One way to get around that bump-up in tax bracket -- and to
reduce the immediate tax bill -- is to convert only a
portion of your traditional IRA each year. Investors who
convert to a Roth also have the option of reversing the
transaction up until Oct. 15 of the following calendar year.
If you are required to take annual distributions from your
traditional IRA, you must take this year's payout before
converting any or all of the remaining balance to a Roth.
IRA specialists also say investors should discuss their
plans for their IRAs with their attorneys as part of the
overall estate-planning process.
While the latest tax-law change may prompt some additional
Roth conversions, IRA specialists generally don't expect a
huge volume. Most people just don't like to pay tax before
they have to, "even if you can convince them it's a better
deal," says Justin Ransome, a senior tax manager in the
Washington office of accountants KPMG LLP.
Milt Baker CPA Michigan
