New tax laws for 2010 provide a unique opportunity for affluent individuals to convert to a Roth IRA, a move that can potentially allow you to accumulate more wealth for your retirement or heirs than your current retirement plan.
Yet while converting can be rewarding, it’s not for everybody. Mary Ann Spangler Sisco, senior wealth strategist with the Wealth Strategies Group for Northern Trust, outlines four main factors to weigh when considering a conversion to a Roth IRA:
Liquidity: Do you have enough assets outside of the IRA to pay the conversion income taxes? If you have to use assets in the IRA to pay the taxes due at conversion, it may not make sense to convert because you are going to lose tax-free growth on the amount you pay in taxes. In this situation, a partial conversion may still make sense, up to the amount of assets you have available outside of the IRA to pay the taxes.
Future tax rates: If you think you (or your heirs) will be in the same or a higher tax bracket when IRA distributions are made, converting now lets you pay taxes in a lower tax bracket.
Time horizon: If your time horizon is not sufficiently long enough — generally at least seven years before withdrawals are made — the tax-free earnings in the Roth IRA are not going to have enough time to grow to be able to offset the taxes you pay.
Intended beneficiaries: Who will receive the IRA distributions? If you need the money for your own retirement and you have a short time horizon, converting to a Roth IRA likely won’t make sense. However, if you don’t need the money in retirement and intend the money to benefit children or other heirs, it most likely will pay to convert.
Make the Most Out of Your Roth IRA Conversion
It’s not merely a question of whether you should convert to a Roth IRA. Rather, if you do convert to a Roth IRA, how can you do so in the most tax-advantaged way? There are several specific planning strategies that can enhance the conversion benefits.
Charitable planning: If you’re considering a Roth IRA conversion because of the potential benefits to your family or heirs and also want to make charitable donations, there are ways to combine these goals and reduce the cost of the conversion. An example would be to set up a charitable lead trust where the lead annuity recipient is a donor advised fund or private foundation, Sisco says.
“You’re able to take an income tax deduction this year for the contribution to the charitable lead trust, potentially offsetting the entire income tax due as a result of the conversion,” she says. “You’re also benefitting your chosen charitable vehicle (the donor advised fund or private foundation) and you’re benefiting your heirs because they get the appreciation on the assets at the end of the term.”
Investment opportunities: Professional investment advice pre- and post-conversion can add significant benefits. Pre-conversion advice on asset allocation and asset location can help you isolate market impact for targeted recharacterization consideration.
After conversion, it’s important to look at whom your money is intended to benefit and allocate assets accordingly. For example, if you don’t need the assets in the Roth IRA for your retirement, then your investment horizon would shift to align with that of your heirs, so you would likely want a more aggressive portfolio in regards to asset allocation.
Recharacterization: What happens if the value of your IRA decreases significantly after you convert? You can recharacterize, which allows you to essentially undo the conversion and move your money back into a traditional IRA, and avoid paying income taxes on the higher amount. If you convert to a Roth IRA in 2010, you have until October 15, 2011, to recharacterize. This time is useful, Sisco says, because you can use this period to evaluate how the market actually performs and possibly make a retroactive decision to avoid paying unnecessary income taxes. You can always reconvert these assets back into a Roth IRA 30 days later (or in the next tax year) if you deem it appropriate, although after 2010, you will not be able to spread out the payment of income taxes between 2011 and 2012.
To maximize the recharacterization opportunity, creating multiple traditional IRAs prior to the Roth conversion — such as focusing on non-correlated asset classes — is especially beneficial. With this situation, Roth IRAs that decline in value can be recharacterized — avoiding the higher tax bill — while assets that increased in value can remain intact, resulting in paying taxes on the lower conversion value.
Converting to a Roth IRA is not a one-size-fits-all situation, and you should sit down with your advisor to determine if converting is the right strategy for you. “I think anybody who has a retirement plan, either a traditional IRA or a qualified retirement plan from a previous employer, should at least look at a Roth IRA and see if it makes sense for them,” Sisco says.