As an avid fan of the potential benefits of Roth IRA conversions, I was drawn to the headline of Ann Tergesen’s Nov. 5 MarketWatch article, Roth IRA conversions spike sharply.
According to the article, Roth conversion activity at Fidelity through October rose 12% over the same period last year. When asked about this, Ken Hevert, vice president of retirement products at Fidelity Investments, cited a “…growing awareness on the part of investors about the ability to convert assets from a regular IRA to a Roth IRA.”
What is a Roth IRA conversion?
Should you do a Roth IRA conversion now? Before answering this question, I’ll begin by answering another question: What is a Roth IRA conversion? A Roth IRA conversion is the transfer of some or all of the assets from one or more non-Roth retirement accounts into one or more Roth IRA accounts. Eligible non-Roth retirement accounts include traditional IRA’s, SEP IRA’s, SIMPLE IRA’s, and qualified plans, such as 401(k) or 403(b) plans. Distributions from a Roth IRA, unlike other retirement plans, are nontaxable.
When you remove assets from a taxable retirement account and transfer them to a nontaxable Roth IRA account, the value of the assets removed on the date of conversion less any cost basis, is included in your current year’s taxable income subject to income tax. An income tax projection should always be prepared to calculate the projected taxable amount of a Roth IRA conversion and the projected income tax liability attributable to the conversion before proceeding with any conversion.
What are the benefits?
Why should you do a Roth IRA conversion if this will increase your taxable income and your income tax liability before you would normally take distributions from your non-Roth retirement accounts? Here are my six top reasons:
1. Eliminate income tax liability on growth of converted assets.
2. Reduce required minimum distributions (“RMD’s”) beginning at age 70-1/2.
3. Potentially pay income tax on the conversion at a low tax rate.
4. Take distributions from Roth IRA whenever you want subject to the age 59-1/2 and five-year rule and beneficiary Roth IRA rule.
5. Potentially reduce taxable amount of Social Security benefits.
6. Increase potential future income tax planning opportunities.
So, is this a good time to do a Roth IRA conversion?
Assuming that you have one or more non-Roth retirement accounts, you should always be on the lookout for Roth IRA-conversion opportunities. Generally speaking, there are two ideal Roth IRA conversion triggers:
- Significant drop in the stock market
- Conducive income tax scenario
Significant drop in the stock market
I wrote a blog post a little over a year ago, Black Friday – Think Roth IRA Conversion. At the time, the Dow Jones Industrial Average had decreased 1,000 points, or 8%, and was at 12,588. I pointed out that this decline presented a Roth IRA-conversion opportunity. I cited reasons 1, 2, and 5 as justification for considering a Roth IRA conversion at that time. With the Dow currently up 28%, at 16,085 one year later, assuming the market doesn’t revert to its November, 2012 pricing, reason #1 has already played out for individuals who did a Roth IRA conversion last November.
Conducive income tax scenarios
There are six income tax scenarios that lend themselves to proceeding with a Roth IRA conversion. All of them require preparation of a single or multiyear federal and state income-tax projections, including calculation of potential exposure to alternative minimum tax (“AMT”), to determine the amount of non-Roth retirement accounts that should be converted to a Roth IRA.
The six scenarios, including links to my blog posts where I’ve discussed each one, are as follows:
1. No current year income-tax liability: The Ideal Roth IRA Conversion Candidate – Part 1
2. Sale of rental property with large passive loss carry forward: The Ideal Roth IRA Conversion Candidate – Part 1
3. Net operating loss: The Ideal Roth IRA Conversion Candidate – Part 2
4. Large charitable contribution deduction from establishment and funding of charitable remainder trust: The Ideal Roth IRA Conversion Candidate – Part 2
5. Substantial basis in IRA: Two Great Roth IRA Conversion Candidates
6. Surviving spouse in low tax bracket not dependent on IRA with children in high tax bracket: Two Great Roth IRA Conversion Candidates
The reason that I was drawn to the Roth IRA conversions spike sharply MarketWatch article earlier this month is because the first ideal Roth IRA trigger, i.e., a significant drop in the stock market hadn’t occurred. We were, and continue to be, in the midst of the opposite situation, i.e., a raging bull market.
While it’s exciting to see that there’s a growing awareness on the part of investors about the ability to convert assets from a regular IRA to a Roth IRA, unless you fall into one of the six conducive income tax scenarios, this probably isn’t a great time to do a Roth IRA conversion.
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.