Part 1 of this blog post introduced a 5-step Roth IRA conversion strategy for individuals 45 to 60 years old who either own a sizeable traditional IRA or have the opportunity to roll over a sizeable 401(k) plan or other retirement plan to an IRA. Steps 1 and 2 of this strategy was presented two weeks ago in Part 2 and steps 3 and 4 were discussed last week in Part 3.
This week’s post presents the fifth and final step together with a hypothetical case to illustrate the use of this strategy. If you haven’t done so already, I would recommend reading Parts 2 and 3 to learn about steps 1, 2, 3, and 4.
Step 5 – Complete Your Conversion Plan No Later Than the Year Before You Turn 70-1/2
As discussed in the January 11, 2010 blog post, Year of the Conversion, there are two main benefits of a Roth IRA that aren’t available to traditional IRA owners:
- Nontaxable distributions
- No required minimum distributions (“RMD’s”)
No one I know likes to be forced to do anything. In order to realize benefit #2, it’s important to target your conversion plan completion date for no later than the year before you turn 70-1/2. Once you reach this milestone, you will be required to take minimum distributions from your traditional IRA accounts each year based on your traditional IRA account value on December 31st of the preceding year and an IRS table life expectancy factor. Assuming that you complete your Roth IRA conversion plan by the year before you turn 70-1/2, you won’t be subject to the “RMD” rules.
Now that we have completed our discussion of the 5-step Roth IRA conversion strategy, let’s take a look at a hypothetical case. Keeping in mind that you want to (a) have your 2010 conversion amount be larger than in subsequent years, (b) skip 2011 and 2012 if you deferred the taxation of your 2010 Roth IRA conversion income, (c) convert equal amounts thereafter, and (d) complete your conversion plan no later than the year before you turn 70-1/2, let’s make the following ten assumptions:
- Individual age 50 in 2010
- Sufficient liquid nonretirement assets to pay income taxes attributable to annual conversions
- SEP-IRA with beginning of 2010 value of $400,000 and cost basis of $0
- Earnings of 5%
- Annual SEP-IRA contributions of $20,000 through age 65
- 2010 Roth IRA conversion of $160,000
- Taxation of 2010 Roth IRA conversion deferred to 2011 and 2012
- No 2011 and 2012 Roth IRA conversions
- 2013 and subsequent year conversions of $45,000
- Final conversion at age 69 after which SEP-IRA account value = $0
Per the Hypothetical Roth IRA Conversion Strategy spreadsheet, the 2010 value of $400,000, total earnings of approximately $196,000, and total SEP-IRA contributions of $320,000 results in Roth IRA conversions totaling approximately $916,000 by age 69. Not only will the Roth IRA conversions of $916,000 not be subject to additional taxation, 100% of the growth of the Roth IRA funds will escape income taxation provided that the funds remain in the Roth IRA for at least five years from the beginning of the year of each conversion and until age 59-1/2.
It’s important to keep in mind that this is a hypothetical case and actual conversion amounts in a particular situation, assuming a Roth IRA conversion makes sense, will depend on many factors that need to be carefully analyzed for each conversion year.
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.