Financial Security by Design
925.299.0472 or Fax 925.299.0473
e-mail: lingane@post.harvard.edu

Introduction and Summary. This article reviews (End Note 1) the reasons that a Roth conversion can be attractive for certain individuals. The author hopes that this background will provide sufficient understanding to determine whether someone might benefit from conversion and to estimate the approximate amount to be converted.

Effect of Income Tax Rate. Consider two individuals, each with $3,000 before tax. The first chooses to invest this money in a tax deferred pension and, over time, the investment doubles and grows to $6,000.

The second individual chooses a Roth IRA. Since a Roth investment is made with after tax dollars, he must pay a third in tax (28% federal tax bracket plus state tax of about 5%.) The $2,000 after tax investment doubles to $4,000.

Which is more valuable, which has the larger "economic value", the $6,000 IRA on which tax has been deferred or the $4,000 Roth IRA which is tax exempt?

If the marginal tax rate is still one third, the traditional and Roth IRA are of equal economic value if distributed before age seventy. If the marginal tax rate has increased, the Roth IRA has the larger economic value.

Because of graduated tax rates, there is a tendency to pay a higher rate of tax on the large distributions than the rate of tax on the smaller contributions.

Future Income Tax Rates. It is almost an article of faith that "Tax rates will be lower in retirement." However, this is not necessarily true for individuals in comfortable circumstances, as the following example illustrates.

Consider a couple earning about $75,000 annually; their marginal tax rate is about one third. At age 65, their income drops to $40,000 ($20,000 in Social Security benefits and $20,000 from pensions or investments.) Their adjusted gross income (AGI) is about $20,000 since Social Security is not taxed at this income level and their federal and state marginal tax rate is a bit over 15%. AGI and marginal tax rate remain at these levels for the next several years.

This couple have traditional IRAs worth about $500,000. The IRAs grow in value by 10% each year until they begin taking distributions.

This couple are required to begin pension distributions at age 70½. The amount to be taken each year is the prior year ending balance divided by the minimum required distribution factor (MRD Divisor). This factor (End Note 2) is based on the life expectancies of the owner and the designated beneficiary. In this example, the factor is twenty and decreases by one each year (term certain.)

At age 71, the couple must withdraw about $40,000. This is the prior year ending balance divided by the current year factor; that is, $805,000/20. This extra income causes 85% of their Social Security benefits to become taxable and increases AGI to $77,000 (End Note 3.) Because income is higher, their marginal tax rate increases to one third (End Note 4).

The required distribution increases each year due to appreciation within the IRAs and because the life expectancy divisor decreases. Consequently, after a few years, their income becomes large enough that the couple are forced into the next higher tax bracket.

By age 83, the annual distributions have become larger that the annual appreciation within the IRAs and the value of the IRAs begins to decline. None the less, taxable income continues to grow and the couple are pushed into still higher tax brackets in their later years. They end up paying tax at a higher rate than their rate of tax before retirement.

This example illustrates that it is possible to pay high rates of tax late in life because of the minimum distribution rules. Further examples will illustrate that converting to a Roth IRA can reduce the rate of tax paid on pension assets because the tax is paid before the nominal value of the IRA becomes so very large, especially is the conversion is done gradually or in low income years.

Nominal versus Economic Value. The deferred tax makes the economic value of a traditional IRA smaller than its nominal value. Imagine that there were a way to make an extra investment for retirement such that the economic value of your traditional IRA increased to its nominal value. This extra investment would increase the amount of your tax advantaged retirement savings by half.

The way that you invest in a traditional IRA is by converting it to a Roth IRA. You make the extra investment by paying the income tax from non pension assets. It is difficult to earn a better return than investing in a Roth IRA (end note 5.)

Converting has the further benefit of longer tax advantaged growth.

Longer Tax Advantaged Savings. There is no sense in withdrawing money from a tax advantaged portfolio unless you need the money to put bread on your table, and yet this is what the owner of traditional IRA is required to do beginning at about age seventy. In contrast, money can stay in a tax advantaged Roth account until the death of the second spouse. Thus, if all or part of your retirement savings are not needed for living expenses, Roth provides a higher effective after tax investment return after age seventy.

Conversion benefits are measured with reference to a forecast of how you would operate your financial affairs if you do not convert. Be sure that this "base forecast" uses realistic assumptions about minimum pension distributions. For example, if you were to make the unrealistic assumption to distribute your traditional IRA uniformly over twenty years beginning from age 65 (end note 6) even though there were no economic necessity to do so, the traditional IRA would be drawn down more rapidly than is necessary in the base forecast. An accelerated drawdown decreases the time for tax-deferred compounding and makes the base forecast appear less attractive than it really is. This in turn biases the calculated benefits in favor of conversion.

It is my practice to delay withdrawals from any IRA for as long as possible in order to gain the most tax-deferred compounding. Consequently, the distribution from a traditional IRA is the larger of an emergency distribution to balance income and expenses or the minimum distribution over the joint lives of husband and wife refigured annually (end note 7.)

Estate Tax is based on the nominal value at death. Even though the economic value of a $600,000 traditional IRA may be similar to the economic value of a $400,000 Roth IRA, the traditional IRA attracts extra estate tax.

Your heirs are entitled to a Schedule A income deduction for the estate tax paid on the traditional IRA and, in principle, this deduction should compensate for the extra estate tax. The deduction does not fully compensate because there is no deduction for state "pickup" (death) taxes, because estate rates are graduated and because the Schedule A deduction is limited at higher incomes.

Non IRA assets equal $1 million (end note 8.) The applicable exclusion amount is also $1 million. The effect of lower income was simulated by assuming the IRA is split between two beneficiaries at MFJ tax rates. The cost of paying estate tax before receiving an income tax benefit has been neglected. 691c.xls.

This extra tax provides an economic incentive to convert to a Roth IRA before the second death except when the heirs will pay income tax at a lower rate, as could happen if the IRA is being distributed among several beneficiaries. See table. All forecasts herein assume that any balance remaining in a traditional IRA is converted to a Roth IRA in the year of the second death.

Each individual’s specific circumstances should be analyzed before deciding for or against a death bed conversion since the benefit depends on tax rates, the size of the taxable estate and on how the IRA will be distributed after death.

After Death Benefits. IRA benefits do not end at death. Assume that the decedent has an investment portfolio with an economic value of $350,000 and a million dollars in other assets. The heirs receive $1,205,000 after taxes.

Now let us assume that the $350,000 were the economic value of an IRA at a 41% pre-death income tax rate. Beneficiaries of a traditional IRA sometimes (end note 9) have the option of gradually withdrawing money over their lifetimes while the beneficiaries of a Roth IRA always have the option of gradually withdrawing money over their lifetimes.

Incidentally, conversion allows one to name new beneficiaries and to set a new post death distribution schedule. This can provide a fresh start to someone whose heirs are locked into rapid distributions from a traditional IRA.

If the IRA beneficiaries were to take distributions over thirty years, the net present value of a traditional IRA and of the other assets on the date of death would be $1,434,000 after all taxes (end note 10.) A portfolio with a Roth IRA instead of a traditional IRA of the same economic value has a similar valuation. These increases reflect the benefits from the continued tax sheltering of the economic value of the IRAs for thirty years after death.

If the traditional IRA were converted immediately before the date of death and distributed over thirty years, the converted IRA and the other assets have a $1,572,000 discounted value. The portfolio with the converted IRA is worth more than the portfolio with a traditional IRA because the conversion process has the effect of tax sheltering additional dollars after death.

Who Benefits From a Conversion? A conversion makes sense for someone

• Whose income will be higher when making withdrawals from their traditional IRA, or whose income is unusually low in the year of conversion. That way, changes in marginal tax rates work in your favor.

• Whose assets exceed their expenses for a long time into the future. That way, you achieve extra tax advantaged investing past age seventy.

• Who can pay the income tax without recognizing deferred income; that is, who can pay the tax from bonds rather than from the IRA or appreciated capital assets. That way, you increase your tax advantaged savings.

• Whose heirs are willing to take distributions gradually over their lifetimes.

• Who is near death. Death bed conversions can substantially increase the economic value sheltered after death and can also provide a fresh start to someone saddled with an unfortunate post death distribution schedule.

Roth Conversion Analysis. Before starting a cross country trip a number of years ago, I asked a mechanic to check my car over. I knew that I needed new tires but I wanted to reduce the risk that I had overlooked another problem.

The fact that you are considering a Roth conversion makes this an ideal opportunity for a financial checkup. You might be OK if you use one of the simple Roth calculators, just as I might have been OK if I had simply bought new tires, but the only way I know to reduce the risk of neglecting an important variable or an important interaction among variables is to conduct the Roth analysis in the context of a review of your overall financial and estate plan.

To carry this analogy further, comprehensive planning reduces risk but does not guarantee a trouble free future. Indeed, my fuel pump failed in Kansas. Planning cannot guarantee a specific result because we don’t know whether the underlying assumptions will be borne out by future events. Words like "best" and "maximum" are predicated on a specific set of assumptions and the actual results will be different from those forecast.

Illustration. Consider Bill and Sue, 45 years old with two children, wages of $90,000 a year, a $225,000 home and a $115,000 mortgage (end note 11.)

Bill and Sue have saved $75,000. Bill has a $50,000 IRA and they are contributing 10% of their wages to tax deferred pension plans. At age 65, their combined Social Security benefit will be $1,600 a month (in today’s dollars.)

Bill and Sue are projecting an 8% investment return and 3% cost of living increases. (Cost of living affects living expenses, Social Security benefits and tax brackets.) They expect wages and their home to appreciate 4% annually.

Basic living expenses are $48,000 a year. In addition, they have mortgage expenses, Social Security and Medicare taxes and California and federal income taxes. Their health is good and they want their financial plan to work up to ages 90 and 94 respectively.

The next ten years are heavy financial sledding. Bill and Sue can’t seem to save anything and they even have to stop contributing to their pension plans while the girls are in college. Their modified adjusted gross income (Figure 1, left hand scale) increases gradually because of inflation and real wage growth. The increased AGI while the girls are in school is because Bill and Sue could not afford to pension contributions and thereby lost the pension deduction.

Their income falls immediately upon retirement. It increases at age seventy onwards due to required minimum distributions. The drop in income at about Bill’s age 90 reflects the decrease in Social Security benefits upon his death.

Figure 1 also displays the rate of tax paid on each pension distribution. The marginal tax rate before retirement is about 35%; this is the rate of tax saved when they make a pension contribution. Tax on post retirement distributions is paid at a rate in the high teens, except for the death bed conversion in the year of the second death. The average rate of tax paid on the all pension distributions is about 20%.

If Bill and Sue were to convert to a Roth IRA (end note 12), Figure 1 suggests that they would pay the least tax on the conversion by converting when other income is low between retirement and before age seventy. Figure 1 even allows them to estimate how much they could convert each year without increasing the rate of tax over what they would be pay on the IRA distributions without conversion.

Figure 1. Income Forecast and Tax Rate on IRA Distributions, without conversion.

Figure 2 is the forecast of Bill and Sue’s balance sheet, of what they own. Future expenses has been included to help understand what is going on.

The gradual increase in expenses is the result of inflation. The increased expenses while their daughters are in college is delineated. The decrease at age 65 reflects the final mortgage payment.

Their cash flow difficulties while their daughters are in college are reflected in the decline in taxable investments and in the slowed rise in their IRA accounts. Once the girls are out of school, the IRA and taxable portfolios recover and increase strongly until Bill and Sue retire at age 65.

Bill and Sue know that the best financial result is obtained by delaying pension distributions as long as possible and they therefore draw upon their taxable portfolio for living expenses. The resulting decline in the value of their taxable portfolio is arrested at age seventy when mandatory distributions begin from their pension accounts. By age seventy five or thereabouts, the required pension withdrawals have grown to more than their needs and the taxable account begins to grow once more. Alert: Bill and Sue are Roth conversion candidates because their required distributions are more than their needs.

Figure 2. Expenses (right hand scale) and account balances (left hand scale) without conversion.

Valuations are before income tax except in the final year. Note that the remaining IRA balance has been converted to a Roth IRA in the final year for the reasons discussed previously.

Sue’s executor summarizes their assets at the second death:

(These are future values, fifty years hence. Divide by a factor of four or five to remove the effect of inflation.)

This asset distribution provides a further hint that Bill and Sue are Roth conversion candidates. As discussed previously, their heirs would receive more value if the estate involved a larger Roth IRA and a smaller investment portfolio (end note 13) even if the economic value of Sue’s estate were unchanged.

How much should Bill and Sue convert to provide the largest benefit for their heirs? To determine this, simulations were performed with different conversion strategies, looking for the strategy which produces the largest increase in wealth at the second death. The results appear below.

Converting gradually over several years often produces larger benefits. (Converting in 1998 is only special because the conversion income can be spread over four years without the bother of making multiple conversions.)

Converting 4 - 6% a year after retirement, or about $200,000, provides the heirs the greatest benefits, something on the order of an extra quarter of a million future dollars.

To put this benefit into perspective, a quarter of a million dollars is equivalent to about 18 months of extra living expenses for Bill and Sue fifty years hence. Another way to look at this benefit is that Bill and Sue could spend an extra $75 a month in retirement and be in the same financial position at the second death. Or, converting provides a cushion against a quarter point decline in market return during retirement.

With no conversion, Bill and Sue pay an average income tax of 20% on IRA withdrawals. Converting lowers the tax on the IRAs to between 16 and 19%.

Post death benefits have not been included and could double these results (end note 14.)

Risk Mitigation. Conversion benefits are not large compared to market, life expectancy and political uncertainties. It is prudent therefore to examine the impacts of alternative scenarios. If you are lucky, the action decision "How much do I need to convert to achieve a good share of the future benefits" will not be sensitive to the uncertainties inherent in these calculations.

The optimum conversion amount is often a broad maximum; converting a bit more or a bit less does not change the benefits very much. If this is your situation, converting less than the "best" amount lowers your exposure to political or economic risks that might make conversion less attractive.

Roth conversions benefit those who have extra resources. If the government is looking for tax revenues in a future year, some may ask "Is it fair that the rich people who converted to Roth are not paying their fair share of income taxes?"

The Alternate Minimum Tax (AMT) system was created to insure that everyone pays their "fair" share of income taxes. One pays the larger of the regular income tax or an alternative tax equal to 28 percent of your entire income less a substantial deduction. Most of the deductions from Schedule A are eliminated and some income which is not taxed in the regular system is taxed under AMT. For example, interest on the certain municipal bonds and the gain on exercising certain stock options are subject to AMT but not regular tax.

It is easy to imagine the politicians voting to treat appreciation within a Roth IRA account as AMT income, thereby taking away the tax exempt status for high income individuals without affecting most voters.

In order to reduce the risk of this or other adverse future events, consider converting only so much as to achieve most of the benefits. If the political or economic climate becomes more favorable, you always have the opportunity to convert more at a later date, assuming the rules are not changed.

Determining the Conversion Amount Without A Roth Simulator. I am often asked, "Where can I buy software to do a Roth conversion calculation?" I don’t know of a commercial product that can reproduce the calculations that have just been illustrated. While several simulators can make the financial forecast, I am not aware of any which also does a year by year tax forecast.

It’s prudent to test any software forecast against qualitative reality checks. These same qualitative criteria should may you to design a reasonable conversion strategy even if you don’t have a comprehensive simulator.

For example, it should be possible to generate Figures 1 and 2 using a good financial simulator (end note 15.) You or your advisor will need to estimate the average rate of tax paid before and after retirement, meaning that the results will be approximate, but the results may be serviceable in spite of this approximation.

Several qualitative design conclusions can be derived from Figures 1 and 2.

• There is an incentive to convert because retirement income exceeds expenses. Also, the heirs are slated to receive a substantial taxable portfolio whereas they would be better off with less cash and a larger Roth IRA.

• A good time to convert would be between retirement and age 70. This is the period when you have the least other income and you will pay the least tax.

• Converting more than $75,000 a year probably leads to extra tax.

A good financial simulator should also be able to forecast the balance in the taxable account at age seventy without conversion. Since one should not accelerate pension distributions by converting so much as to exhaust the taxable portfolio before age seventy, and since one should keep some money as an emergency fund, you should be able to determine that the extra funds from which to pay the tax are $50,000 - $100,000. If the rate of tax is 20%, the cash balance forecast limits the conversion to $250,000 - $500,000.

Figure 3 is a forecast of account balances after conversion. The traditional IRA (solid circles) is depleted more rapidly than it was in the absence of conversion (open circles.) and goes to zero at just about the time of the second death. The low valuation of taxable investments late in life suggest that the post death deferral opportunities have been maximized. These qualitative observations usually indicate situations where conversion makes sense.

Figure 3. Account balances assuming the conversion of 4% of the IRA balance each year from 2018 through 2022 ($160,000 total.)

Forecasting account balances is a qualitative tool to identify a reasonable conversion strategy. Figure 4 suggests that converting 10% a year for five years is too much. This causes the IRA to be depleted before the second death.

To use a financial forecaster to estimate the conversion amount, define a "cost" at ages 66 through 69 equal to the amount you wish to convert plus associated taxes. For example, converting $350,000 over five years, as in Figure 4, corresponds to a "cost" of about $85,000 a year including taxes. (1.2 * 350/5 = $84,000.) If you vary this "cost" until the forecast is similar to Figure 3, you probably stand a good chance of identifying a reasonable amount to convert.

I have not proven the validity of this approximate approach. It is presented here, without warranty, as a possibility rather than as a recommendation.

Figure 4. Converting 10% of the IRA balance each year from 2018 through 2022 ($350,000 total.)

It is a good idea to analyze your own situation even if you eventually go to a professional for assistance. Analyzing a customer’s situation and building the base forecast is labor intensive. If you have done part of the analysis before meeting with your adviser, you will save money.

Converting at Different Ages. The Bill and Sue scenario allows us to address the question "Is there at best age at which to convert?" We can examine this question by determining the strategy (i.e., amount and timing) which provides the largest wealth benefits at several ages. This "best" strategy is shown in the table. The symbol K means thousands; i.e., $20K means $20,000.

Wealth benefits are stated both as an increase in after tax net worth at the second death and as the number of equivalent extra months of living expenses.

It has been said that the Roth IRA is more beneficial the further you are from retirement. What the commentators mean is that the benefit from converting the same amount of money is larger for younger individuals. For example, converting $20,000 at age 45 produces a five fold benefit per dollar converted as compared to the half fold benefit from converting $300,000 at age 75.

The largest benefits are not necessarily at the youngest ages. In this scenario, the largest benefits occur by converting between retirement and age seventy.

Benefits from gradual distribution after death have not been addressed.

Should The Younger Individual Convert? The younger investor has the option of converting now or converting later. He should focus on the incremental benefits of converting now as compared to waiting until retirement. These incremental benefits, which have not been discussed here, are generally very small and sometimes are even negative.

Delay reduces planning risk by foreshortening the financial forecasts on which the conversion strategy is based and protects against the risk that the rules will be changed in ways that make the Roth IRA less attractive.

The younger investor probably has other financial priorities.

For these reasons, I usually suggest that the younger individual not convert unless their current income is low or unless they are sure that their income will be increasing (an inheritance perhaps) or unless they are convinced that the conversion opportunity will be repealed before they retire.

Funding the By-Pass Trust. Many couples create a "by-pass" or "credit shelter" trust at the first death. Money in this trust is sheltered from estate tax at the second death. It is available to the surviving spouse should he/she need it and whatever is left over passes to the ultimate heirs upon the second death.

This trust is usually funded to the maximum level possible without paying estate tax at the first death. The funding target is typically $625,000, an amount which is scheduled to increase to a million dollars in coming years.

If the trust is to be $625,000 and if all of a couple’s assets are owned jointly, they need $1.25 million to be able to fund the by-pass trust at the first death.

It may not be possible to fund the by-pass trust at the first death without using IRA assets. If IRA assets are left to the by-pass trust, minimum distributions begin immediately. Since distributions from a traditional IRA are taxable, a by-pass trust funded with a traditional IRA is going to shrink by half after paying income tax at high trust rates. A tax exempt Roth IRA avoids this shrinkage.

Therefore, a consideration when deciding which IRA to convert is to determine whether either spouse might need a Roth IRA to fund the by-pass trust.

Post death funding of the by-pass trust with pension and community assets is a complex and evolving area of estate planning. Seek competent advice.

Income Taxation of IRA Conversions and Distributions. If your IRA is a rollover from a 401(k) or 403(b) plan, all the money in your account is tax-deferred. If you made non deductible contributions to your IRA, part of the money is tax paid. When you withdraw from an IRA, and a conversion is a special type of withdrawal, there is no income tax liability on that portion of the distribution which reflects tax paid contributions. The tax free portion is determined by aggregating all of your IRAs and the income tax liability is the same no matter from which IRA you make the withdrawals.

Suppose an individual has two IRA accounts, each worth $100,000. The basis in the first is zero and the basis in the second is $10,000. If $100,000 is withdrawn from either account, the taxable income is $95,000.

Suppose that these accounts were owned by a couple. If the spouse with zero basis withdrew his entire account, the taxable income would be $100,000. If the spouse with $10,000 basis withdrew her entire account, taxable income would be $90,000. So, if the goal was to convert $100,000 and pay the least tax, the couple should convert the account of the spouse with the higher basis.

If you don't know what your basis is, check your prior tax returns; it should appear on IRS Form 8606. If you do not have your prior returns, request copies from the IRS. This takes several months and costs $14 per return but could save you thousands in tax.

Basis for state income tax purposes may be different from the federal basis; it is in California. See a tax professional if you need help.

1998 Income Averaging. If you defer the tax on part of your 1998 conversion income and if you die, any remaining deferred income is reported on your final income tax return. If the Roth account passes to your spouse as sole beneficiary, she may continue the income deferral per the original schedule.

If you elect to defer tax on 1998 conversion income and make a full withdrawal of the Roth account before 2002, all remaining deferred income is accelerated into the year of withdrawal. If you make a partial withdrawal, only part of the remaining deferred income is accelerated.

IRA Proposed Regulations 1.408A-6 provides examples illustrating these rules.

Four year income averaging for 1998 conversions is optional for federal but not California purposes. You may save money by paying all the tax in one year if

• Your income will be higher over the next three years

• You have AMT preference income this year

• You have a net operating loss, charitable contribution or AMT carryover.

Given that you will be paying tens of thousands of dollars of tax on a conversion, it’s probably worth getting advice specific to your circumstances before assuming you should pay the tax over four years.

Estimated Tax Payments. Whether you pay the tax over one year or four, the basic principle is that the tax is payable in the quarter when you earned the income. If you convert in the fourth quarter, the tax is due January 15th.

The second principle is that you never need to pay more in estimated tax than an amount equal to last year’s tax liability (end note 17) and, if you pay this liability equally over the four quarters, you never owe underpayment penalties. If this is your situation, then the extra tax on the conversion income is not due until April.

Since state tax is a deduction from federal income, it may be advantageous to pay the fourth quarterly state estimate in late December rather than in early January. This allows you to take the state payment as a deduction for federal income tax purposes in the current year.

Large state tax payments, especially when combined with large capital gains income or AMT preference income from stock options or municipal bonds, can change the pay in December strategy. The point is that you should develop a schedule of tax payments that minimizes both income tax and underpayment penalties. Paying an 8% underpayment (interest) charge for a few months may be cheaper than liquidating securities at a bad time or triggering AMT tax.

Which Assets to Use to Pay the Tax. Avoid pulling money out of appreciated assets to pay the conversion tax since this accelerates capital gains tax.

Paying a large tax bill from bonds, as in this example, will probably overweight your portfolio in terms of its stock allocation. Therefore, as part of your Roth conversion decision, you need to consider how you are going to rebalance your portfolio after you have paid the taxes.

Consider adjusting the Roth account first since this does not accelerate taxes.

After tax return often improves if you hold bonds in a traditional IRA and stocks in a taxable account. With a Roth account, it is better to hold the investments with the higher return in the Roth account (end note 18.) This suggests that the second re-allocation might be to overweight stocks in the Roth account.

In order to re-allocate stock investments from the taxable to the Roth account without accelerating capital gains tax, consider re-investing taxable dividends and the gross proceeds from taxable stock sales in a taxable bond portfolio. Make a compensating bond to stock adjustment within the Roth account.

Beneficiary Designation. Whether or not you decide to convert, you should probably review your IRA beneficiary designations.

Do not name your spouse as the co-beneficiary of a Roth account without consulting with the IRA plan administrator. The surviving spouse might not be allowed to delay distributions and to name new beneficiaries unless she is the sole beneficiary (end note 19.) If your spouse is one of several beneficiaries, it may be wise to create separate accounts for each beneficiary.

It may also wise to create separate accounts if your beneficiaries are of different ages or will have different financial imperatives after your death.

Avoid naming the estate as the beneficiary of an IRA account. If someone dies before age 70½ owning a traditional IRA, or at any age owning Roth, naming the estate means that the account must be distributed within five years (end note 20.) This limits the opportunity for post death tax sheltering. A by-pass trusts can be a beneficiary without accelerating distributions under certain conditions.

Avoid dollar amounts in IRA beneficiary designations. A "pecuniary bequest" triggers income tax recognition.

Recharacterizing a Roth Conversion. One reason to delay a Roth conversion until late in the year is the possibility that your income may exceed the hundred thousand dollar ceiling (end note 21.) If you made an IRA withdrawal and were prevented from converting to a Roth IRA, the consequences are severe: the distribution is taxable, there is no four year income averaging, there may be early withdrawal penalties and you lose the benefit of future tax deferral.

New federal legislation allows you to reverse or "recharacterize" a Roth conversion prior to the deadline for filing your tax return. Check your state rules. The California FTB issued a Legal Ruling allowing recharacterization (end note 22.)

If your state does not allow recharacterization, the cautious approach is to take the distribution in December but do nothing for sixty days. If your 1998 income is below the ceiling, you can convert the distribution into a Roth IRA. If your income is too high, roll the distribution back into a traditional IRA.

This strategy (end note 23) preserves your eligibility for income averaging and guarantees you won’t end up in the soup if your 1998 income turns out to be too high.

The proposed regulations (end note 24) allow recharacterization for any reason. This means that someone who converted before this summer’s market decline can reverse the conversion at the original market values and reconvert at the current market values, thereby reducing their 1998 income tax liability. Recharacterization also offers the opportunity to reduce the conversion amount, if you decide that you have converted too much.

Prop. Reg. 1.408A-5 Q-6 specifies the recharacterization procedure and provides examples. One may not recharacterize a traditional IRA as a Roth IRA unless the AGI and filing status conversion conditions are met.

The IRS limits recharacterizations to one per year after November, 1998. There are reports (end note 25) that custodians were unhappy with multiple recharacterizations.

Five Year Rules. I do not recommend converting if you intend to withdraw the money in the immediate future. Only death bed conversions will produce a large financial benefit over a short time period. In addition, penalties and taxes could be assessed if you make a withdrawal before five years.

There are two separate five year rules: one applies to tax and penalties on distributed earnings and the other applies to penalties on distributed basis. Warning: California law is different.

Tax and Penalties on Distributed Earnings. Distributions from a Roth account are tax free if you have had a Roth IRA account for five tax years and if you are over age 59½ (or death, disability or first time home purchase (end note 26.))

The five year interval for distributed earnings starts when you make your first Roth contribution or conversion.

If a contribution is with respect to the 1998 tax year, the interval covers the five tax years 1998 through 2002. The Roth account can be withdrawn tax free anytime on or after January, 2003 if the 59½ age requirement is also met.

Since there is only one five year distributed earnings interval, contribution in the year 2000 to a Roth account opened in 1998 can be withdrawn income tax free anytime on or after January 2003 if the 59½ age requirement is met.

If the distribution is after five years but before age 59½, that part of the distribution in excess of basis, that is the earnings since conversion, are taxed.

If you take a distribution from a Roth IRA before age 59½, you are assessed a 10% federal early withdrawal penalty based on the taxable portion of the distribution, that is on the earnings. (California assesses an additional 2.5%.)

Earnings distributed from a decedent’s Roth IRA upon death at age 50 would not be taxed and would not be penalized. Death is an exemption to the age 59½ requirement for both the income tax and early withdrawal rules.

Partial distributions made before five years or before age 59½ may not generate an actual tax liability since basis is recovered first. Until all the basis is distributed, there cannot be a tax or penalty on distributed earnings.

Penalty on Basis. If you take a distribution from a conventional IRA before age 59½, the usual early withdrawal penalty is suspended on that portion of the distribution which is converted to a Roth IRA. For example, if a taxpayer makes a conversion in December 1998, the 10% penalty is suspended and does not appear on the 1998 tax return.

If the taxpayer converts part of the December 1998 distribution, reserving the balance to pay taxes or for other purposes, the early withdrawal penalty applies to the unconverted portion and is reported on the 1998 tax return.

If the converted funds are subsequently withdrawn from the Roth IRA before five years, the penalty is reinstated. For example, if funds converted in 1998 are withdrawn in 2002, before the end of the fifth tax year, an early withdrawal penalty from 1998 is reinstated on the basis distributed in 2002 (if the taxpayer is under age 59½ in 2002 and does not meet one of the penalty exemptions.) The reinstated penalty is reported on the 2002 tax return.

There are separate five year penalty intervals for each conversion or contribution. For example, if the taxpayer makes a Roth contribution in the year 2000, the early withdrawal penalty applies if basis is withdrawn from the Roth account before January 2004 (five tax years counted from 2000.)

If you convert at age 58 and wait two years, the earnings are taxable but there is no penalty on basis or earnings because you are over age 59½ at the time of distribution. If you convert at age 45 and wait six years, the withdrawal of earnings is taxable and subject to penalty but the suspended penalty on the distributed basis is not reinstated because you waited five years.

Gifting a Roth IRA is treated as a distribution and is subject to income taxes and penalties if made before five years and age 59½. The gift is subject to gift taxes if the value is more than $10,000 to any one individual in one year.

Conclusion. A Roth conversion is attractive for those individuals whose assets exceed their living expenses, who can pay the tax from non pension assets, who will live a long time and who have heirs to whom they can leave their money. A death bed conversion can substantially increase post death benefits.

Benefits are modest and adverse economic events or changes to the tax rules could reduce or even reverse the value. Consequently, reduce risk by converting no more than enough to capture most of the forecast benefits.

Paying the income tax on a Roth conversion can distort your asset allocation The state income taxes may trigger federal AMT tax.

Converting to a Roth IRA may ease the funding of the by-pass trust.

Proposed Roth regulations are generally (end note 27) taxpayer friendly and recent federal legislation makes it possible to reverse a conversion.

End Notes

18. For example, a portfolio grows by the indicated factor over a ten year period, assuming 35% federal and state tax on ordinary income and 27% tax on capital gains. STC_10.XLS

19. IRS Form 5305-R "Model Roth Agreement" article V, paragraph 3 reads "If the grantor’s spouse is the sole beneficiary on the grantor’s date of death, such spouse will then be treated as the grantor." Cf. IRS Announcement 97-122, available at http://www.rothira.com/irsforms.htm#97-122.

27. Except 1.408A-4 which denies certain taxpayers the option of choosing the tax year in which to receive the initial required distribution. See http://www.lingane.com/tax/roth/roth_reg.htm.

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