Hidden Gotchas of Roth IRA Conversions

What’s not to like about a Roth IRA? As with traditional IRAs, earnings accumulate tax free. But unlike the traditional IRA, withdrawals are tax-free and minimum distributions after age 70 ½ are not mandatory. Add to this the 2010 special incentives to convert a traditional IRA to a Roth IRA, and it’s a wonder taxpayers aren’t lining up to do the conversion.

Or is it?

Mike Solomon, partner-in-charge of the tax department at the Philadelphia office of Amper, Politziner & Mattia, LLP, said his firm thought so.

“There was so much coverage about this in both the financial press and the popular press that we mobilized for a flood of conversions,” he said.

“Up until 2010, only people whose modified adjusted gross income was $100,000 or less were eligible for the Roth conversion,” Solomon explained. “But Congress, probably looking for additional revenue, removed the limitation for 2010 so that everyone is entitled to convert from a regular IRA to a Roth without any penalties or other limitations on contributions. The advantages are that once your Roth is funded all of the earnings are not deferred, they’re exempt, so whoever takes the money out — whether you or your heirs — will never have to pay any income tax on the earnings.

“Of course, when you convert your regular IRA to a Roth, you have to pay tax on the entire amount,” he added. “The government tried to make this a little less painful, so they said you can pay the entire amount of tax on your 2010 return [due in 2011], or you can choose to split it half-and-half, and pay half in 2011 and half in 2012.

“If that’s not enough, the government gives you another provision to encourage you to convert,” he said. “Say you had $300,000 to convert to a Roth IRA in March 2010, and six months later the market plunges. You now only have $200,000, yet you have to pay tax on $300,000. They allow you to convert it back to a regular IRA by October 15 of 2011 – the extended due date of your 2010 return.

“So you have the ability to split the tax over two years, and the ability to change your mind. These are vey unusual incentives in the law to encourage taxpayers to make the conversion,” he said.

“There’s another benefit to a Roth,” he added. “In a regular IRA, when you’re 70 ½, you have to start taking distributions, but in a Roth there’s no minimum distribution requirement. A lot of people look at this as an estate planning strategy whereby you can leave your heirs all of the Roth IRA without you or your heirs having to take distributions, and when the heirs do take distributions it won’t be taxable.”

Yet the anticipated volume of Roth conversions hasn’t materialized.

“We bought a proprietary program to show taxpayers how much better off they would be by converting,” said Solomon. “Each office had a designated expert for the conversion process, and a designated computer just to do Roth conversions. But when we showed an actual taxpayer how much he and his heirs would save if he would pay $350,000 for the privilege of converting, he practically lost consciousness. It turns out that there are very few taxpayers who want to writer a check for 35 percent of what they’re converting.

“A Roth is extremely attractive on a lot of levels,” he said. “But the barrier is that enjoying tax-free appreciation doesn’t always overcome the cost of paying the tax upfront. When you remove 35 percent of the value of the IRA to pay the tax, you have to make it up in tax-exempt appreciation over a long period of years to get ahead of the game. Most people won’t do it just based on an income tax analysis, but it’s an act of generosity to the heirs that makes it worthwhile for some people with a substantial estate.”

Estate tax considerations have to be paramount for the Roth conversion to be worthwhile, according to Solomon. “And when you pay tax on the conversion, don’t take it out of the IRA,” he said. “If you have $300,000 in an IRA and take out $100,000 to pay the tax, all of the models will tell you it doesn’t work. You have to be willing to fund the Roth with outside assets.”

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