Last week’s post discussed the first three insights to be gained from analyzing two scenarios – one with no Roth IRA conversion and a second with a Roth IRA conversion – that were presented in the April 25, 2011 post, Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 6 of 6. This week’s post addresses three additional insights that can be used when confronted with a Roth IRA conversion decision.
Availability of Nonretirement Investment Assets is Essential
As we saw in the two scenarios in Part 6, the availability of nonretirement investment assets is essential (1) in meeting financial needs prior to distributions from a traditional IRA account where there will be no Roth IRA conversion and (2) in fulfilling income tax obligations related to (a) Roth IRA conversions or (b) distributions from traditional IRA accounts in the case of non-conversion.
In the case of nonconversion, insufficient retirement assets to (a) pay the income tax liability attributable to required minimum distributions (“RMD’s”) from traditional IRA accounts and/or (b) meet ongoing financial needs will result in larger distributions from traditional IRA accounts that will in turn result in a larger income tax liability. Per Exhibit 1 of Part 6 of Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog, the traditional IRA account distribution increased by 30% in the year that this occurred vs. the approximate 5% annual increases attributable to increasing RMD’s up until that point.
Whenever you do a sizeable Roth IRA conversion or series of conversions and the Roth IRA conversion income isn’t sheltered by offsetting losses and/or deductions, a sizeable income tax liability will arise. Per Exhibit 2 of Part 6, there was total Roth IRA conversion income of approximately $236,000 resulting in associated income tax liability totaling approximately $71,000, or 30% of the amount of the conversions over five years. As a result of this immediate and substantial drain of cash, when it came time for taking distributions to meet retirement needs beginning at age 65, the remaining assets in the nonretirement account could only sustain six years of withdrawals before the account was depleted.
Calculation of Projected Capital Gains and Losses is Important
While it was assumed in both scenarios that there would be no capital gains or losses in connection with withdrawals from the nonretirement investment account, the calculation of projected capital gains and losses is important to simulate real life. Unless cash is readily available, there will be a taxable transaction any time that a withdrawal is taken from a nonretirement investment account. As we saw in Exhibits 1 and 2, this will occur in the following three situations:
- Income tax liability attributable to a Roth IRA conversion or series of conversions
- Ongoing distributions to meet retirement needs
- Income tax liability attributable to distributions from traditional IRA accounts
Depending upon the value vs. cost basis of the assets that are liquidated to generate the cash for the withdrawal, there will either be a capital gain or a capital loss. Furthermore, capital gains will either be short- or long-term depending upon how long the assets were held before they were sold, with the latter resulting in favorable tax treatment. To the extent that net capital gains are generated, additional withdrawals from nonretirement accounts will be required to pay the income tax liability attributable to the gains. On the other hand, annual net capital losses in excess of $3,000 can be carried forward to offset future years’ capital gains.
Worst Case Assumptions Should Always be Used
Given the fact that, per insight #1 of Part 1 that actual results are likely to be different than projected results, worst case assumptions should always be used in the preparation of any Roth vs. non-Roth IRA conversion analysis. While there’s a natural tendency to use current interest, inflation, and income tax rates in all projection years since we’re familiar with these rates and it’s easy to do, there’s a strong likelihood that the projected results will be flawed, especially given today’s historic low rates for all three of these items. While many of my readers may not be old enough, I remember 15% interest and 13% inflation rates when I reentered the working world after receiving my MBA in 1980.
In addition to using worst case assumptions, multiple Roth vs. non Roth IRA projections should be prepared to simulate a wide range of possibilities. Having said this, you don’t want to prepare so many projections that you suffer from analysis paralysis.
I hope that the six-part Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog plus this two-part Roth IRA Conversion Insights series enables you to look at Roth IRA conversions from a new perspective.
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.