by Barry C. Picker, CPA/PFS, CFP
© 1998, Barry C. Picker
The following copyrighted article is available exclusively on the Roth IRA Web Site:
In 1997 Roth IRAs were enacted, effective the beginning of 1998. Since that time we’ve had Technical Corrections, Proposed Regulations, and various IRS Notices, including the latest one which put a limit on how many times a taxpayer can go back and forth between their traditional and Roth IRAs. We’ve also added new words to our vocabulary like recharacterization (the act of moving your IRA conversion back to a traditional IRA, or moving your annual IRA contribution from a traditional IRA to a Roth, or vice versa) and reconversion (the act of taking that recharacterized conversion and putting it back into a Roth). Add all this together with the advertising hype, and it’s no wonder there is widespread confusion. But the worst thing that can happen is for taxpayers to throw up their hands in frustration, and possibly lose out on one of the best tax breaks to come down the pike in a long time.
Let’s get one thing straight from the get go. The banks, brokers and mutual fund companies talking Roths, conversions and the like are looking to be the custodian/trustee of your IRA money, whatever type. They make money from having your money. There is nothing wrong or sinister about this, but they are not the people to be talking to about tax related decisions.
Before we get into a discussion about the pros and cons of Roth IRAs and conversions, let’s review the basics.
A Roth IRA is a new breed of IRA effective as of January 1, 1998. Named for Sen. William Roth of Delaware (he got it named for himself because he can), this IRA promises tax free income, as opposed to a traditional IRA’s tax deferred income. Contributions to the Roth IRA are not tax deductible. But as long as the Roth IRA has been in existence for more than five tax years, and the withdrawal is made after the account holder has attained age 59½, or the withdrawal is made on account of death or disability or is for a qualified first time home purchase, the earnings in the account will be totally free of income tax. In addition, contrary to a traditional IRA, contributions to a Roth IRA can be withdrawn at any time without income tax or penalty. Earnings withdrawn from a Roth IRA that does not meet the criteria for tax free treatment, will be subject to income tax, and may also be subject to the 10% early withdrawal penalty.
Not everyone is eligible to make a contribution to a Roth IRA. In order to qualify, a taxpayer must have earned income, at least in the amount of the Roth IRA contribution. For married couples, either spouse can have the earned income, so that a spouse with no earned income could still make a Roth IRA contribution, as long as the other spouse has earned income. There is also a maximum income cap for taxpayers to be eligible to make a Roth IRA contribution. For married taxpayers filing a joint return, the ability to fund the Roth IRA starts to phase out at $150K of modified adjusted gross income (MAGI), and disappears completely at $160K. For single taxpayers, the ability to fund the Roth IRA starts to phase out at $95K of MAGI and disappears completely at $110K. For married taxpayers filing separately, the phase out starts at $0 and ends at $10K.
Taxpayers who have existing traditional IRA accounts may be eligible to convert their accounts into Roth IRA accounts. The requirements are that the modified adjustment gross income not exceed $100K, and, for married taxpayers, that a joint return be filed. In the case of married taxpayers, the $100K income limitation is for the couple’s joint income. (Once again, the married taxpayer gets the shaft). For taxpayers who desire to convert to a Roth, and whose income is close to the threshold, certain steps can be taken to reduce their MAGI. Among the steps are to move money in interest bearing accounts into either tax free bonds, or Treasury bills that will be taxed in 1999 (Treasury bill interest is taxed at the bill’s maturity, even though it is paid up front). Don’t worry about paying a penalty if you break a Certificate of Deposit, as the penalty will reduce MAGI. Taking capital losses will also help, particularly if you have capital gains. Also useful is putting money into 401(k)’s, 403(b)’s, Keoghs, SEPs and SIMPLEs, to the extent that you are eligible. But putting money into an IRA will not help.
Taxpayers who convert their traditional IRA to a Roth IRA will recognize income to the extent that they would have recognized income had they withdrawn the IRA funds. But the 10% early withdrawal penalty will not be imposed on the conversion. However, if a converted amount is withdrawn from the Roth within five years of the year of the conversion, the 10% penalty would be applied to that withdrawal, unless an exception to the penalty applies (being over 59½ is the most notable exception). For conversions that are taxed in 1998, the taxpayer can recognize this income over a four tax year period. But a withdrawal of money from the Roth in 1998, 1999, or 2000, would result in the reported income being accelerated. For conversions in later years, the conversion will be taxed fully in that year.
Now that the basics are out of the way (more detailed information can be obtained from any one of a number of articles on the Roth IRA web site located at www.rothira.com), should one be in a Roth IRA? The most asked question is, should one convert their existing IRA into a Roth? The answer is, (drum roll, please) it depends.
One no-brainer concerning Roth IRAs is that if one cannot deduct their contribution to a traditional IRA, they should definitely contribute to a Roth IRA, if eligible.
Another no-brainer concerns taxpayers over the age of 70½ who are taking mandatory distributions that they don’t need, and their IRA is set up in such a way that the IRA will be required to pay out the entire balance upon the account holder’s death. These are accounts that most likely do not have a proper beneficiary designation in place, and it is too late to correct it. By converting to a Roth, the account holder gets a second chance to set up the account with a proper beneficiary designation. The retrieval of the ability to continue the tax free growth after the account holder’s death can result in significant wealth to the heirs.
A taxpayer contemplating converting their existing IRA to a Roth is usually better off doing so in 1998 than in a later year. For one thing, that will start the five year clock on the Roth account’s existence running. More importantly, the taxable income resulting from the Roth conversion will be spread over four tax returns, unless the taxpayer chooses to include it all in their 1998 tax return.
The most likely candidate for conversion is a younger taxpayer with a relatively small IRA balance, in a low tax bracket, and with cash to pay the resultant tax without disturbing the IRA funds. But I have found that the taxpayer who will get the most benefit out of converting is an older taxpayer with a large IRA balance and a high net worth. The problem many times is that such a taxpayer has income in excess of $100K. But if such a taxpayer can end up with income low enough to be eligible to convert their IRA, they, and their heirs, will undoubtedly benefit from their doing so.
It is important to remember that there is no requirement that an entire IRA account be converted. Partial conversions are permitted. This is even more important in years later than 1998 when the entire conversion must be included in income in one year. For this reason, even if one is unable to effect a conversion in 1998 but can do so in 1999, a conversion should be considered for at least a portion of the IRA account at that time.
The taxable income that results from a conversion is determined by the value of the account on the date of the conversion. Since account values can fluctuate (especially in accounts heavily laden with equities, which most IRA accounts should be), it is possible to convert the IRA to a Roth at one value, only to have the account value decline substantially after that date. The tax law has an out in such a case, and that is ability to "recharacterize", or undo, the conversion. Once the conversion has been undone, the taxpayer could then do another conversion to a Roth, which would be taxable at the new, lower, value. However taxpayers no longer have the right to do this again and again. Once a taxpayer reconverts, they can no longer undo the conversion and reconvert in order to get a lower taxable value. Taxpayers do still have the right to undo the conversion, leaving the funds in their traditional IRA. This might be the preferable way to go if, even after a reconversion, the account value continues to drop substantially in value. One would then be able to do a conversion in the following year.
The easiest way to effect a conversion is to open a Roth IRA with the same trustee/custodian as the traditional IRA, and have them move the funds into the Roth. If you wish to change the trustee/custodian, you most likely will have to either effect a trustee to transfer of the traditional IRA funds to the new trustee, and then convert to a Roth, or convert to the Roth with the old trustee, and then do a trustee to trustee transfer of the Roth IRA. It is also possible to convert to a Roth by taking actual control of the traditional IRA funds and then depositing the funds into a Roth within 60 days. If you take control of the IRA money in 1998, the conversion will count as a 1998 conversion even if the money is not deposited into the Roth until 1999 (within the 60 days). Should you go this route, there is no mandatory withholding of income tax on a distribution from an IRA account. The mandatory withholding applies to employer accounts, such as 401(k) accounts. However if you take the withdrawal in 1998 and deposit the money into the Roth in 1999, the Roth itself will be considered as having come into existence in 1999, for purposes of the five year rollover rule (withdrawals within five years of a conversion are subject to the 10% penalty unless an exception applies).
A recharacterization must be effected by a trustee to trustee transfer. Again, the easiest way to do it is by keeping the account with the same trustee. However, any time a trustee is being less than cooperative, an account can always be moved to a more cooperative trustee. In fact, it would be a good idea when setting up the Roth account, to inquire of the trustee what restrictions they may have on recharacterizations and reconversions. Keep in mind that a recharacterization can be done any time up to the extended due date of the tax return of the year of the conversion that is being undone. The harder question is when should a recharacterization be done.
If the recharacterization is being done because it must then it should be done as early as possible. There is no advantage to putting it off. The worst possible thing to happen is that an improper conversion has been done, and is not recharacterized in a timely fashion. (This could also occur because of an audit that increases the MAGI, which would be a major problem). If an improper conversion is NOT recharacterized, then the resultant Roth IRA would contain excess contributions that will result in a 6% penalty each year, until withdrawn. In addition, the money that came out of the traditional IRA will be fully subject to income tax in the year of the conversion, and will be subject to the 10% early withdrawal penalty, unless an exception applies. All in all, this is a loser all the way around, unless Congress amends the law to remove this harsh result. It is imperative that this be avoided.
But let's get back to a voluntary recharacterization, done because of a stock market decline. When is the best time to do it, taking into account that there is only one opportunity in each year to recharacterize and reconvert? There is no real best answer. Let’s look at different possibilities.
If one has already converted their IRA to a Roth in 1998, or even if one is first doing a conversion now, then there is one chance to recharacterize and reconvert before the end of the year. Pay close attention to any time restraints placed by your custodian. At least one broker has already announced that the deadline for conversions is December 15th, in order to permit them time to do all the paperwork by December 31st. So don’t expect to run into your broker’s office on December 30th to get a recharacterization and reconversion done in one day. Keeping that in mind, the recharacterization/reconversion should be done if there has been a significant decline in value of the account, since the conversion. Of course, ‘significant’ can mean different things to different people. But since the brokers need time to run the paper work, and the reconversion is taxed based upon the value on the date of the actual transfer back to a Roth, one can end up doing a reconversion at a higher value, should the relevant values increase. Remember also, that the recharacterization is irrevocable, so if it turns out that the original conversion works out to be the better deal, too bad.
For any 1998 conversion, whether reconverted before the end of 1998 or not, there is the opportunity to recharacterize the conversion in 1999 (up to the extended due date of the 1998 tax return) and then reconvert to a Roth. Such a reconversion will be a 1999 conversion, and therefore not subject to the advantageous four year income spread that a 1998 conversion has. It would also mean that the five year penalty period for conversions will start in 1999, not 1998. Therefore, it would take a very significant drop in value to overcome the loss of the four year income spread. These will have to be analyzed on a case by case basis.
If one is going to do a conversion in 1999 (for example, if 1998 income will exceed $100K but 1999 income will not), then there will be one chance to recharacterize and reconvert the account in 1999. Since the stock market tends to go up in most years, the conversion should be done as early in the year as possible. The hard part will be deciding when to do a recharacterization/reconversion, should the market decline next year. In theory, the optimal time to do so would be when the account value is at the lowest point of the year. However, if truth be told, if I could predict that with any accuracy, I would not be writing articles! This is something you will just have to play by ear.
In looking at whether it is beneficial to convert an IRA account to a Roth, it is important to keep in mind that the balance in the traditional IRA is a before tax balance, while the balance in the Roth is, except for early withdrawals, an after tax balance. For example, if a taxpayer has $100K in a traditional IRA, the taxpayer does not have $100K for their use; the same balance in a Roth would represent money for their use (once the taxpayer is over 59½ and the account has met the five years in existence requirement). For that reason, a conversion to a Roth where the tax is paid from outside funds is the equivalent of putting additional money into the IRA. Another benefit of conversion is where the taxpayer may have a need for IRA funds prior to age 59½ (not that I ever recommend using retirement account funds for anything but retirement). But once funds are converted to a Roth IRA, the taxpayer can withdraw those funds tax and penalty free after five years, even if the taxpayer is nowhere near age 59½.
One place where Roth conversions can be very advantageous is in the estate planning arena. Traditional IRAs are subject to both estate tax at the death of the account holder, and then income tax when the funds are withdrawn. By converting to a Roth, the taxable estate is reduced by the income tax paid on the conversion. The Roth beneficiary is then left with a tax free account that can continue to grow as it is paid out over the beneficiary’s life expectancy.
What is clear from my analysis, is that looking strictly from the taxpayer’s personal financial picture, a Roth conversion is better for a younger taxpayer. But if one looks at the larger family financial picture, converting even after the taxpayer is taking required distributions can result in increased family wealth. One can leverage this tremendously by naming grandchildren as beneficiaries, thus stretching the payout period over many decades.
Admittedly, with so many factors and different taxes to take into account, the determination of whether it is beneficial to convert an existing IRA to a Roth is not an easy one. Some people have tried to simplify the decision by focusing solely on relative income tax brackets. The fact that one may be in a lower bracket at retirement is but one factor to consider in the process, but it is far from the factor to consider. Another common error I see is using the same earnings and growth rate inside the IRA and outside the IRA, ignoring the fact that taxes must be paid on earnings on funds outside the IRA.
While a large number of taxpayers and their families would benefit from a conversion to a Roth IRA, there are some taxpayers who should not convert. One example is a taxpayer who wishes to leave his or her IRA to a charity at death. Such a taxpayer should leave the IRA as a traditional IRA, and name the charity, or a charitable trust, as the beneficiary of the IRA.
Well, the Roths are here, and when all is said and done, they’re a nice gift from the government. We owe it to the Congress to take all the advantage we can of their largesse.
The Author:
Barry C. Picker is a Certified Public Accountant with the Personal Financial Specialist
designation, and is a Certified Financial Planner licensee. He runs his own accounting and
financial planning firm located in Brooklyn, NY, and is also a member of the NYS Society
of CPAs Estate Planning Committee. He has taught seminars and written articles on tax
topics, and has been quoted in various publications. In addition, he is part of a panel
that answers tax questions on America Online at keyword:TaxLogic. He can be reached at
(718) 934-4300, or via E-Mail at BPickerCPA@cs.com.