As stated last week in Part 2 of this series, there are three primary potential economic benefits to be derived from a Roth IRA conversion, with the first one being the most important and overriding reason in most cases for doing a conversion: (1) elimination of taxation on 100% of the growth of Roth IRA conversion assets, (2) elimination of exposure to required minimum distributions on traditional IRA funds converted to a Roth IRA, and (3) potential reduction in taxation of Social Security benefits. Benefit #1 is the subject of this post with the other two benefits to be discussed in Parts 4 and 5 of this series, respectively.
There are many situations in life that require a leap of faith in order to realize the potential benefits from our decision that result in actually implementing a particular course of action. Like many people, buying my first house comes to mind as one of those such moments. It’s natural for us to simply think of the immediate impact of a particular decision on our daily lives. In the case of my first house purchase, the monthly mortgage payment and all of the other expenses and responsibility associated with home ownership loomed before me as formidable obstacles. It wasn’t until I was able to visualize the long-term potential benefits of my decision that I was able to feel comfortable with signing the dotted line.
Implementing a Roth IRA conversion that requires payment of income taxes today that otherwise wouldn’t be payable for several years in many cases can be a similar experience for many people. Until one visualizes and understands the number one potential benefit and power of a Roth IRA conversion, i.e., elimination of taxation on 100% of the growth of the Roth IRA conversion assets, the traditional IRA that was being considered for conversion will remain untouched.
One of the best examples that I can share with you regarding visualization of potential benefits in connection with a Roth IRA conversion is that of one of my clients, who I will call Mary. Mary had a sizeable IRA account that was formerly her deceased husband’s IRA. She was taking annual required minimum distributions (“RMD’s”) from her IRA, the amount of which was approximately $35,000 in 2008. In 2009, which was the year when RMD’s were waived and Mary wasn’t required to take any distributions from her IRA, Mary, who was 80 years old at the time, did a partial Roth IRA conversion of approximately $100,000, or 20%, of the remaining value of her IRA of approximately $500,000.
Why would an 80-year old who had sufficient nonretirement investments to live on take any distributions from her IRA in a year when she wasn’t required to do so, i.e., 2009, incur income tax liability of approximately $37,000 in connection with her Roth IRA conversion, and, furthermore, not wait until 2010 to do her conversion when she would have the ability to defer 50% of the income from her conversion to 2011 and the other 50% to 2012? Not only didn’t she “let the tax tail wag the dog,” Mary, at her advanced age, was able to visualize the elimination of taxation on growth of her Roth IRA account during not only her remaining lifetime, but also that of her daughter as well.
To put things in historical perspective, the stock market had been spiraling downward, with the Dow Jones Industrial Average decreasing from a high of about 14,000 in October, 2007 to a low of around 6,500 in the beginning of March, 2009. At the time when Mary did her Roth IRA conversion in March, 2009, a sizeable portion of which was invested in equities, the Dow was right at about 7,000. With the Dow closing at 12,321 on Friday, subject to a potential future decline in value, Mary has experienced a 75% increase in just two years in the value of the equity portion of her Roth IRA that will never be taxed. With approximately half of her Roth IRA invested in equities, the appreciation of Mary’s Roth IRA account since she did her conversion in March, 2009 has already exceeded the income tax that she paid in connection with her conversion. The growth in Mary’s Roth IRA will never be taxed during Mary’s lifetime nor that of her daughter.
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.