In early 2010, there was great fanfare over the repeal of the $100,000 modified adjusted gross income limitation. As the 2010 tax year came to an end, many tax professionals felt that Roth IRA conversion planning had lost its relevance as an effective income tax planning strategy, given that income tax rates were set to increase to their pre-2001 levels as of January 1, 2011. However, with the reinstatement of the so-called "Bush tax cuts" under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Roth IRA conversions have once again become a powerful short-term and long-term income tax planning strategy, especially in 2011 and 2012.
Understanding the Basics of Roth IRA Conversions
While understanding Roth IRA conversions has neither been nor will ever be easy, over the years there have been a few general rules of thumb which have proven to be useful from a broad perspective. However, the best way to truly understand and analyze Roth IRA conversions (and take advantage of its benefits) isn't by following the over-generalizing rules of thumb or by devising some complicated mathematical theorem to find an "optimum" conversion amount. Rather, the best way to understand Roth IRA conversions and analyze them properly is to develop several fairly straightforward spreadsheet analyses whereby certain key variables are modified. Accordingly, the following is a summary of key variables that need to be identified and addressed in order to best analyze a Roth IRA conversion:
1. Asset mix (i.e., qualified versus nonqualified, liquid versus illiquid)
2. Traditional IRA balance
3. Time horizon
4. Current and future cash flow needs
5. Current marginal tax rate versus projected future marginal tax rate
6. Ability to pay the income tax with nonqualified funds
7. Estate planning objectives
Types of Roth IRA Conversions
Once the key variables behind Roth IRA conversions have been identified, the next step is to determine what type of conversion best suits the current situation.
The key objective behind this type of Roth IRA conversion is to take advantage of short-term economic conditions that are expected to reverse over time. For example, a taxpayer whose traditional IRA contains stock that is expected to incur significant growth within the near future may benefit from converting to a Roth IRA. As opposed to holding the stock in a traditional IRA, holding the quickly-appreciating stock in a Roth IRA would allow the stock's growth to occur completely tax-free. The concept of converting by asset class to multiple Roth IRAs with the tactic of recharacterizing the underperforming asset classes is another example of an "opportunistic conversion".
Joe is currently considering converting $300,000 to a Roth IRA in 2011. One of the assets in his traditional IRA ($100,000 of ABC Inc. stock) has a lot of upside potential within the next year. The other two assets ($100,000 of LMN Co. stock and $100,000 of XYZ Corp. stock) are difficult to determine how they will perform. Accordingly, Joe converted his single traditional IRA into three separate Roth IRAs, one for each asset.
On April 15, 2012, each Roth IRA had the following values:
Based on the results above, Joe recharacterized Roth IRA #2 and Roth IRA #3 back to a traditional IRA. By doing this, Joe only paid income tax on a $100,000 conversion which is now worth $150,000, thereby saving future income tax on the $50,000 of post-conversion growth.
The key objective behind this type of IRA conversion is generally motivated by wealth transfer. Considering that Roth IRAs are not subject to "required minimum distributions" ("RMDs") when the IRA owner reaches age 70½, converting a traditional IRA to a Roth IRA will allow the IRA assets to continue to grow tax-free for a longer period of time, thus allowing greater wealth to accumulate for future generations. An ideal candidate for strategic conversion is one who (1) possesses "outside funds" (for example, nonqualified investment accounts) from which to pay the tax on the conversion, (2) anticipates being in the same or higher marginal income tax bracket in the future, (3) does not need to make withdrawals from the Roth IRA to meet his/her annual living needs, and (4) desires to leave a tax-free asset to his/her children or grandchildren.
This type of Roth IRA conversion is executed to take advantage of unused, short-term, special tax attributes that the taxpayer may otherwise not be able to utilize. A non-exhaustive list of these types of tax attributes includes NOL carryovers, current year ordinary losses, unused charitable contribution carryovers, nonrefundable tax credits, as well as alternative minimum tax credit carryovers. By converting to a Roth IRA, the taxpayer generates enough taxable income to fully utilize these tax attributes. If done correctly, the taxpayer could pay little to no income tax on the conversion.
This type of Roth IRA conversion is done as a "hedge" against a future tax increase. Hedging conversions can be further subdivided into two types of conversions: (a) income tax hedging conversions and (b) estate tax hedging conversions. Both types of hedging conversions are generally executed during the current time period so as to lower overall taxes in the future, taking into consideration the potential for higher income tax rates and/or estate tax rates that could be enacted by Congress.
During the short time period of 2011 and 2012, there is a "window of opportunity" for people to take advantage of lower income tax rates, thereby sheltering future growth from higher income taxes. If analyzed appropriately using Roth IRA conversion software and executed properly, the wealth passed on to future generations can be astonishing.
*Editor's Note: This article was originally published in the April 2011 issue of The WealthCounsel Quarterly, published by WealthCounsel.