Are there circumstances when it makes sense to convert today from a traditional individual retirement account to a Roth IRA and not wait until 2010? What about converting over a period of years rather than all at once, or borrowing funds to pay the Roth conversion tax liability? Let’s see.
Assume this hypothetical example: John Smith has a $250,000 traditional IRA and is eligible to convert to a Roth IRA but does not have funds outside the IRA to pay the resulting tax liability. Smith will attain age 70 1/2 in 2017, and therefore will be required to start taking Required Minimum Distributions (RMDs) that year. When Smith dies at age 85 in 2032, his daughter Jane will stretch her payments under the IRA for the maximum time permitted by law. Finally, assume all investments earn 7% and the applicable income tax rate is 35% unless otherwise noted.
Now let’s compare the after-tax income distributed to Smith and his daughter if he retains his traditional IRA or, alternatively, converts to a Roth IRA in 2008. In the case of conversion, Smith uses some of the IRA funds to pay the resulting tax liability since he has no other available funds for this.
Example 1, in the chart, summarizes the results of the two alternative approaches and shows just how much additional after-tax benefit the Roth offers. The $250,000 traditional IRA will provide $4,018,033 in after-tax funds for Smith and his daughter by the time the funds have been completely distributed to Jane in 2061. However, by converting the IRA to a Roth IRA, the $250,000 IRA will provide $5,133,642 in after-tax funds for the two by the time the funds have been completely distributed. So, the Roth will provide $1,115,609 of additional after-tax benefit, or around 28% more in after-tax dollars, when compared to the traditional IRA.
This example confirms the significant benefit of conversion to a Roth IRA, which benefit is largely derived from the absence of RMDs for the Roth and the ability to continue to benefit from the tax-free growth offered by a Roth IRA.
But how does this Roth conversion opportunity compare to waiting and converting in 2010? Examples 2 and 3 show why waiting and converting in 2010 may or may not be a wise planning strategy.
In Example 2, where tax rates remain constant at 35%, the after-tax benefit increases by $90,034 to $5,223,676. This additional tax planning benefit is presumably created by the ability to pay the Roth conversion tax liability over two years in 2011 and 2012, a tax deferral benefit available only for amounts converted in 2010. The general conclusion, then, is that it is wise to wait until 2010 to convert to a Roth IRA if tax rates remain unchanged.
But what if tax rates increase before Smith can convert in 2010? For example, what if the rates increase to 43% in 2010 and Smith decided to wait to convert? This is Example 3, and the increased tax burden upon conversion reduces the overall value of the Roth IRA to $4,352,696.
While that’s still better than not converting at all, failing to take advantage of the opportunity to convert in 2008 would have cost the Smith family $780,946 when compared to Example 1. That is, by waiting to convert and converting at a time that income tax rates were higher, there is a reduction of $780,946 in after-tax value.
Clearly, there may be situations where it would make sense to convert today based on increasing income tax rates. And in a time of growing revenue needs for entitlement spending, such as Social Security and Medicare, the risk of increasing income tax rates may well be a real concern for many individuals.
Another reason to consider converting now and not waiting for 2010 would be a change in law eliminating the repeal of the conversion income limits. The modeling here assumes Smith is eligible to convert in all years, but there is no guarantee that he will be eligible to convert in 2009. Further, if Congress repeals the elimination of the income limit for conversion, which is supposed to go into effect in 2010, then Smith would have lost the one-time opportunity to convert to a Roth IRA.
Thus, it may make sense, again assuming eligibility in 2008, to convert some IRA assets and lock in some of the after-tax benefit afforded from conversion.
The above examples assume that the conversion occurs in one year. But what if Smith believes he will be eligible to convert in 2009 and thereafter and decides to convert over 4 years, beginning in 2008? Example 4 models that situation and the results are slightly better still, since the after-tax advantage from conversion increases by $23,000 when compared to the complete 2008 conversion (Example 1).
The advantage to converting over 4 years is both this slight enhancement in value and the locking in of some conversion benefit in case Congress acts to reinstate income limits for conversion.
Still another planning possibility would be to tap a home equity loan to pay the entire conversion tax liability in 2008. Example 5 assumes a 9% interest rate charge on the home equity loan used to pay the conversion tax liability; it also assumes that the interest is fully deductible, and that the loan is repaid over 4 years from the IRA funds (allowing the funds needed to pay the conversion tax liability to grow tax-free for up to 4 more years).
The resulting enhancement to the Roth IRA after-tax conversion benefit is $240,431 (when compared to Example 4), while also avoiding the risk of future ineligibility to convert (whether from current law income limits or the reinstatement of such limits effective in 2010). This may be the optimal strategy for the individual who is eligible to convert today, is concerned about future eligibility, and must use the traditional IRA funds to repay the tax liability.
For those currently eligible for conversion, consideration should be given to whether income tax rates will rise before 2010 or if there is risk that Congress will re-introduce conversion income limits before the pending liberalization becomes effective.
While waiting for 2010 may be the best course of action absent such changes, an individual may wish to forfeit some of the potential upside of waiting to convert for the certainty of getting the conversion done. If this decision is made, then the individual should consider whether to convert in one year or to convert over time, and whether to finance the resulting tax liability by borrowing to pay the resulting tax liability.
As demonstrated, the economic benefits of conversion can be enhanced depending on the strategy deployed. In general, conversion to a Roth IRA is optimal and the actual strategy for the conversion will depend on individual circumstances and the risks of future ineligibility for conversion and increased income tax rates.
Robert Fishbein is vice president and corporate counsel in the tax department of Prudential Financial, Newark, N.J. His e-mail address is email@example.com.