Clearing the Roth IRA Conversion Hurdles

I liken the Roth IRA conversion decision-making process to the 100 meter (women) and 110 meter (men) high hurdles events in track and field.

Should you convert your traditional IRA’s to Roth IRA’s? This question is a hot topic this year with the repeal of the $100,000 modified adjusted gross income barrier for converting traditional IRA’s to Roth IRA’s. Last week’s blog post, Three Roth IRA Conversion “Show Stoppers” discussed three scenarios where the answer is a definitive “no.”

Assuming that none of the three “show stoppers” are applicable to your situation, you’re ready to lace up your running shoes and step onto the track. I liken the Roth IRA conversion decision-making process to the 100 meter (women) and 110 meter (men) high hurdles events in track and field.

Before discussing the various hurdles, once again it should be noted that a Roth IRA conversion doesn’t have to be an all-or-nothing event – you can do partial conversions over one or more years. The other important thing to keep in mind is that just because 2010 is the first year that you can convert your traditional IRA to a Roth IRA doesn’t mean that this is “the” year to do it. The hurdles discussed in this blog may be applicable to you this year, however, next year may be a totally different story.

Although the 100 meter, in the case of women, or the 110 meter, for men, high hurdles is a relatively short race, clearing ten hurdles 3.5 feet in height while running an all-out sprint is no easy feat. Likewise, there are three “high hurdle” situations when it comes to converting a traditional IRA to a Roth IRA as follows:

  1. Payment of Roth IRA conversion tax liability requiring liquidation of assets resulting in additional tax liability
  2. Withdrawals anticipated within five years of Roth IRA conversion
  3. Individuals with life expectancy of five years or less with no beneficiaries

Payment of Roth IRA Conversion Tax Liability Requiring Liquidation of Assets Resulting in Additional Tax Liability

One of the three “show stoppers” discussed in last week’s blog post was no source of funds for payment of Roth IRA conversion tax liability outside of retirement plans. If your nonretirement liquid assets, i.e., checking, savings, credit union, and money market funds are limited and you will need to sell securities to generate funds to pay the income tax liability attributable to a Roth IRA conversion, will you be creating additional income tax liability as a result of those sales?

If the result of your sale(s) will either be a capital loss or a capital gain that can be offset by either a capital loss carryover from the previous year or a capital loss generated earlier in the current year, then this isn’t problematic. If, on the other hand, your securities sales will result in a capital gain that cannot be offset by a capital loss, you will incur income tax liability in addition to the liability from doing a Roth IRA conversion. At a minimum, even if the securities that you sell were held for one or more years resulting in favorable long-term capital gains treatment, your tax liability from the capital gain will be at least 15% of the amount of your gain plus state tax liability. If significant, this additional tax liability on top of the tax liability attributable to the Roth IRA conversion could be a deal killer.

Withdrawals Anticipated Within Five Years of Roth IRA Conversion

Any distributions from Roth IRA conversions that aren’t attributable to non-deductible IRA contributions will be taxable as ordinary income if they’re taken within five years of January 1st of the year of the Roth IRA conversion.

If your situation is such that there’s a good chance that (a) you will need to take a withdrawal from your Roth IRA conversion within five years of January 1st of your Roth IRA conversion, (b) most of the distribution won’t be attributable to non-deductible IRA contributions, and (c) the income from your projected withdrawal isn’t projected to be sheltered by losses and/or itemized deductions or you aren’t otherwise projected to be in a lower tax bracket than in the year of conversion, a Roth IRA conversion probably doesn’t make sense. This is especially true if you will be less than 59-1/2 when you are projected to take your withdrawal since a 10% premature distribution penalty will be assessed in addition to the tax attributable to the income from your withdrawal.

Individuals With Life Expectancy of Five Years or Less With No Living Beneficiaries

Whenever analyzing the potential viability of a Roth IRA conversion, it’s important to keep in mind that, while the numbers may not favor a conversion if the analysis is based solely on the IRA owner’s life, this may not be the case when beneficiaries are considered, especially younger non-spousal beneficiaries, assuming that the Roth IRA isn’t projected to be depleted during the Roth IRA owner’s lifetime.

On the other hand, If you’re in a situation where either you’re very advanced in age or otherwise have a life expectancy of five years or less and you have no living beneficiaries who will inherit your IRA, the potential benefits to be achieved from a Roth IRA conversion probably won’t exceed the income tax liability attributable to the conversion in most cases.

So, you weren’t eliminated from the Roth IRA conversion game by any of the three “show stoppers” discussed in last week’s blog and you cleared all three “high hurdles” in this one. Are you a candidate for a Roth IRA conversion? Read next week’s blog post to learn the answer to this question.

By Robert Klein

Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.