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Should You Consider a ROTH Conversion? by Dennis J Rogers, CPA, CFP®

            Most people have the largest part of their investments for retirement in qualified plans (tax deductible at contribution and tax deferred until withdrawn).  These plans (IRA’s, TSA’s, 401(k)’s) are generally advantageous during the higher income years because contributions to these plans are tax deductible.   

            ROTH IRA’s (or ROTH(k)’s) may be a beneficial alternative for some people.  We discussed the advantages of that in my previous article so I will not go into the details here.  It may also be to your advantage to convert some of your IRA / 401(k) to a ROTH.  This involves the transfer of some of your account to a ROTH and paying tax on it, but no 10% penalty regardless of your age.  You then have the balance in the ROTH which will grow tax free as well as some other advantages.  These conversions are now allowed regardless of a taxpayer’s modified adjusted gross income. 

            Once you have it in a ROTH you will be able to take distributions tax free as long as the account has been open for at least 5 years and you have reached age 591/2  There are also exceptions for death, disability, and qualified first-time home buyers.  So, you pay no more tax once the funds are in the ROTH and there is also no tax on the withdrawal of funds.  In essence you have tax-free growth on the funds.  There are also no required minimum distributions on the account for the rest of your life. 

            Part of the challenge in determining if a ROTH conversion is the best option for retirement income is that you have to make some assumptions about tax rates in the future.  If your future tax rate will be lower than your current rate, you are probably better off sticking with the traditional IRA.  You should have more money after you pay tax on the withdrawal than you would if you paid the tax on the transfer and then invested the smaller amount in the ROTH.  You should also consider the current year impact of higher income on taxability of Social Security benefits, Medicare premiums, and phase out of many deductions, credits, and allowances based on income.    

            Here is an example:  you convert $50,000 from your IRA when your tax rate is 30%.  You pay the tax of $15,000 (with other funds) and invest in the ROTH and average 9% return for 15 years.  You would then have $182,125 in the ROTH.  If you took 5% annual withdrawals with no tax, you would net $9,106 per year.  However, if you kept the funds in the IRA and did not pay the tax, the $65,000 amount would grow to $236,761 in that 15-year period.  Your 5% annual withdrawal would be $11,838.  If your tax rate were now only 15%, you would have $10,062 left each year after tax.  That is $956 more each year.[1] 

            Another strategy for taxpayers who would like to contribute to a ROTH but are not allowed due to income limitations is what has been referred to as a back-door ROTH.  This involves opening and funding a non-deductible IRA and then converting it to a ROTH.  There is little or no tax because the IRA is non-deductible.  In effect, the outcome is the same as if you could directly fund a ROTH. 

            There is a catch to this one.  The Internal Revenue Code requires a pro rata allocation between taxable and nontaxable amounts when a conversion is done.  That means that if you have taxable IRA’s and you convert an after-tax one, you must consider the amount proportionately to determine how much is taxable.  So, if you have an IRA with $90,000 and non-deductible IRA with $10,000 and you convert the $10,000 one, you will have to pay tax on 90% of the conversion ($9,000).  If you have an employer plan that allows for roll-overs, you could roll the taxable IRA into that plan.  Employer plans are not considered in the pro rata calculation so you should be able to avoid tax on the conversion.  

            Even if the conversion is not the best option for retirement income purposes, it still might make sense from a legacy perspective.  If you are confident you have more resources than you will need in your lifetime and would like to maximize the benefit to the next generation, a ROTH conversion could be a way to accomplish that.  Your heirs will inherit the account tax-free and can take tax-free withdrawals. 

            Of course, if your legacy beneficiary is a qualified charity, it would be better to keep it in the IRA, since the charity will not pay tax on it if it is used for their exempt purposes. 

Dennis J. Rogers, CPA, CFP® is a Registered Principal offering securities and advisory services through United Planners Financial Services. Member FINRA/SIPC. The information contained in this article is general in nature.  You should seek professional tax and financial advice prior to implementing any of these ideas.  Rogers & Kirby and United Planners Financial Services are not affiliated. He is a partner in a financial advisory practice in Phoenix that focuses on helping clients make smart decisions about their money based on their personal core values. He can be reached at dennis@rogerskirby.com or 602-748-1900.


[1]The average return shown is for illustrative purposes only. Past returns are not a guarantee of future returns.