Roth Conversions for High Income Earners

First the Facts

Conversions from regular IRAs to Roth retirement accounts for high income earners increased more than nine times in 2010, rising to $64.8 billion from $6.8 billion in 2009, according to recently released data by the Internal Revenue Service.

That marked the first time Roth conversions were greater than contributions. Conversions were especially common among IRA holders with annual incomes exceeding $1 million. More than 10 percent of them converted to a Roth account, the IRS said.

The increase in conversions stemmed from a 2006 law that set 2010 for ending a $100,000 income limit on Roth conversions. There’s no ceiling on conversions if an investor has multiple IRAs and no cap on the amount that can be shifted. Congress passed a similar law in 2013 allowing for easier conversions into Roth 401(k) accounts.

Taxpayers with incomes exceeding $1 million made up 4 percent of the 869,400 Roth conversions in 2010; they moved $14.4 billion, or 22 percent of the money.

Assets in individual retirement accounts, known as IRAs, totaled $6 trillion as of Sept. 30, 2013 according to the Investment Company Institute. Almost four out of 10 U.S. households owned IRAs in 2013, ICI data show. About 16 percent of U.S. households, or 19 million, have Roth IRAs compared with about 36 million owners of regular IRAs in 2013, according to the ICI.

Wealthy investors can better manage their tax liability in retirement and pass the Roth accounts to heirs free of income tax. If your IRA account is not necessary for you to live on during retirement, this is potentially a very powerful, low cost estate planning strategy and you’re paying the taxes for your beneficiaries.

Contrasts between Traditional and Roth

Contributions to a regular IRA are tax-deferred, with up-front deductions and taxes owed when the money is withdrawn from the account, appreciation is tax deferred. At 70 ½ you are generally required to begin taking distributions.

In contrast, Roth accounts are built with post-tax money. The appreciation within a Roth account is not subject to tax. Roth IRA’s waive the annual required minimum distribution. Roth distributions are tax-free during your lifetime and Roth accounts inherited by your beneficiaries are tax-free over their lifetimes.

If Converted

Generally, converted assets in the Roth IRA must remain there for at least five years to avoid penalties and taxes. Distributions from a Roth IRA are tax-free and penalty-free provided that the five-year aging requirement has been satisfied and at least one of the following conditions has been met:

• You reach age 59½
• You pass away
• You become disabled
• You make a qualified first-time home purchase

But if you pay taxes on a conversion at a higher rate than you would have owed on traditional IRA withdrawals, it does take time for tax-free earnings to overcome that disadvantage. Just how long depends on the difference in tax rates and the performance of your investments, so making the switch may not make sense. Or you may consider converting just part of your traditional IRA assets. Having both traditional and Roth IRAs gives you tax diversification. It may even help you avoid falling into a higher tax bracket.

As with any tax and investment strategy, consult an accredited investment advisor or a tax advisor before making any decision regarding conversion.

CBlakely, CFP®, CTFA                                      Jan 2014

Sources: Bloomberg News, Vanguard, Fidelity