Practitioner’s Check List to Roth Conversions

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A Practitioner’s Guide to Roth Conversions

©1998 Peter James Lingane
Financial Security by Design
925.299.0472 or Fax 925.299.0473
e-mail: lingane@post.harvard.edu

Prepared for presentation January 21, 1998
East Bay Chapter, California Society of Enrolled Agents

It is by now well established that there can be substantial wealth and estate tax benefits on converting a traditional IRA to a Roth IRA. These benefits primarily flow from the tradeoffs among three factors (ref. 1).

When the tax rate at the time of conversion is higher than the rate that would be paid on pension withdrawals in retirement, the Roth IRA is less tax efficient than a traditional IRA.

Consequently, clients should convert when their tax rate is unusually low or if they expect to be in a higher tax bracket when retired. A newly retired couple, a new graduate or someone between jobs might be in an unusually low bracket. Someone expecting an inheritance might be in a higher tax bracket later in life.

Appreciation within a Roth account is generally (ref. 2) tax exempt. Consequently, paying the tax on the conversion income from non pension assets offers an opportunity to shelter additional money from further tax.

A client should convert only so much that he can pay the tax from non pension assets without unduly accelerating the time when he must draw upon his unconverted pensions for living expenses.

Because Roth accounts are not (ref. 3) subject to the minimum distribution rules that apply to traditional IRAs, conversion allows tax exempt compounding to continue up to the second death, and beyond.

Conversion is attractive for the client with resources in excess of expenses since he is less likely to need to draw upon Roth assets during his lifetime.

Converting to Roth is a major financial decision and an improperly designed conversion could cost the client tens or even hundreds of thousands of dollars. A tax adviser who relies on approximations or rules of thumb risks an unpleasant conversation with his liability carrier.

The first step is to understand the client’s financial goals and to collect the basic information necessary to forecast the value of the client’s pensions and other assets from the present until death, escalating expenses and tax brackets. Forecasting is easier and more certain if the client is no longer concerned with college educations and mortgages and if their assets have been accumulated. Focus on a single scenario as this exercise can easily mushroom into a full fledged financial plan.

Conversion benefits are the difference between the base forecast and alternatives chosen to test various conversion scenarios. The goal is to identify the conversion scenario that produces the most wealth and the least IRD at the second death.

Benefits can be expressed in ways that are attractive to the client. For example, the 62 year old couple with $1.2 million described in reference 2 could:

Leave an extra $250,000 to their heirs; or,

Spend an extra $1,500 a year for the rest of their lives; or,

Live an extra two years without fear of depleting their resources; or,

Spend an extra $20,000 a year on long term care late in life.

A conversion plan should address the following issues.

Accurate tax forecasts are essential and software must model the effects of graduated tax rates and any differences between federal and state law. Some popular financial planning packages (ref. 4) assume that tax rates are independent of income and are not be appropriate for designing a Roth conversion.

Be alert to the special taxation of capital gains and to the exclusion of gain on the sale of a personal residence. Wealthy clients who convert large IRAs may incur AMT after 2001 because of the drop in ordinary income after conversion. Also, appreciation within a Roth account may become an AMT preference item.

Use a realistic pension distribution strategy for the traditional IRA account. For example, annual withdrawals should be the larger of an emergency distribution to balance income and expenses or the minimum required distribution over the client’s life or over the joint lives of husband and wife. Consider withdrawing any remaining balance from a traditional IRA just before death, or before the second death if a married couple. Use Roth assets last.

This strategy gains most (ref. 5) of the benefit from tax deferred compounding and eliminates estate tax on IRD income. Other distribution strategies bias the calculated benefits in favor of conversion. The error introduced by an unrealistic distribution strategy can lead to a wrong recommendation.

Develop a five year, or longer, cash flow projection. The planning challenge is to pay the tax as slowly as possible without recognizing unrealized gains and without disturbing the asset allocation within the investment portfolio.

A client with bonds and appreciated stock should probably pay the tax from the bonds, rather than recognizing capital gains, assuming he has the flexibility to adjust the bonds in the Roth account so as to re-establish the desired stock to bond allocation ratio. For example,

	Stocks	Muni Bonds	Taxable Bonds
Before Conversion Taxable Account IRA Account	$500,000 $500,000	$500,000 -	- $500,000
After Conversion Taxable Account Roth Account	$500,000 $300,000	$100,000 -	- $700,000

Base 1998 estimated tax payments on the safe harbor rules (ref. 6), a decision that must be made before April 15, 1998 for optimum effect.

For example, a client might owe $24,000 tax under normal circumstances. Converting in 1998, which qualifies for income averaging, might increase his tax liability by $400,000 during the period 1998 - 2001. The table illustrates that this client can defer most of the 1998 tax bill to April 1999. (The tax burden is smaller each year because paying the tax decreases the next year’s investment income.)

Year Paid	Federal and state estimated payments	Additional Payment with T/R in April
1998	one fourth of 1997 tax or about $6,000/qtr.
1999	$30,000/qtr.	$95,000.
2000	$30,000/qtr.	$15,000.
2001	$30,000/qtr.	$5,000.
2002	$6,000/qtr.	$5,000.
2003	$6,000/qtr.	small

A cash flow projection allows the planner to be sure the client does not run afoul of the five year rule (ref. 7). This rule causes withdrawals from a Roth account before January 1, 2003 to be "non qualified" and lose their tax exempt status.

Income tax is not an important consideration if the client withdraws only part of his Roth account since basis is recovered first (ref. 8). However, pending legislation (ref. 9) would impose a penalty on these withdrawals when the taxpayer is less than age 59+ at the time of conversion and would impose a further penalty on withdrawals from any conversion made in 1998.

The choice of beneficiary (ref. 10) is critical.

Do NOT name the client’s spouse as a co-beneficiary of an IRA or Roth account; create a separate account for each beneficiary. The surviving spouse is allowed (ref. 11) to delay distributions and to name new beneficiaries only if she is the sole beneficiary.

Avoid naming the client’s estate as the primary beneficiary of an IRA account. If the client dies before age 70+ owning a traditional IRA, or at any age owning Roth, naming the client’s estate means that the account must be closed out within five years (ref. 12) and eliminates the option of further tax deferral.

Avoid using pension assets to fund a by-pass (marital, credit shelter) trust. If the client must use these assets, have her consult an experienced estate planner. An experienced planner is likely to recommend funding the by-pass trust with Roth assets rather than with a traditional IRA because there is no tax shrinkage when the Roth account is distributed.

Consider converting the entire IRA of the "poorer" spouse if the spousal estates are dissimilar in value, if this enhances the by-pass trust of the poorer spouse, if she has a higher basis in her IRA (as a percentage of assets) or if the poorer spouse has the longer life expectancy.

Be especially cautious when advising the younger client. Bear in mind that the younger client has the option of converting after retirement. His decision is not "Should I convert?" but "Should I convert now or should I convert later?" or "Should I convert some now and some later?"

The younger client enjoys several advantages. He can tax shelter more money earlier and he may not be pushed into so high a tax bracket (ref. 13) by the conversion income. On the other hand, paying the tax now could be a significant hardship, the forecast of his financial situation late in life is less certain and there is more risk that he will be in a low tax bracket after retirement due to unexpected illness or other factors.

Incremental conversion benefits (ref. 14) for the younger client are not large because IRA balances are modest when one is young and because these clients could gain most of the benefits by converting when they retire. Whether the benefits are large enough to dominate their decision making is difficult to judge without a full picture of the client’s circumstances, goals and ambitions.

Only if a client is confident that their tax rate in retirement will not be lower than at the time of conversion, or if she is concerned that the rules may change, can the client be sure that converting now is the prudent course.

Be sure that the client understands the uncertainties inherent in any financial plan. Run sensitivities to the rate of inflation, to the investment return, to the ages at death and to the other important variables. The results may lead the client to convert a bit more or a bit less.

Be sure that the client understands the interaction of conversion timing and market performance. If the value of his investments declines immediately after conversion, the client pays more tax than if he had waited until after "the correction that everyone knows is coming." But, if the client waits for the correction and financial markets continue to soar, he will end up paying more tax when he eventually converts.

Manage the client’s income to be below the $100,000 conversion ceiling (ref. 15). Delay conversions until income is certain or until pending legislation, allowing taxpayers to transfer from a Roth IRA to a traditional IRA without tax or penalty before the due date of their tax return, is adopted (ref. 16).

If the client exceeds the ceiling, she might face an immediate tax bill and lose future tax deferred compounding and, if she is under age 59+, she might get stuck with an early distribution penalty.

The cautious approach is to take the distribution in December but to do nothing until January. If the client’s income is above the ceiling, he can roll the distribution back into a traditional IRA (ref. 17) within 60 days without tax or penalties. If his 1998 income is below the ceiling, he can roll the distribution into a Roth IRA (ref. 18) within 60 days without penalty.

Since qualification (ref. 19) for income averaging requires that the distribution be in 1998, this strategy preserves the client’s eligibility for income averaging while guaranteeing he won’t end up in the soup if his 1998 income is too high.

For example, Lingane, P. J., "Should You Convert to a Roth IRA," AAII Journal, November 1997. This article is available at http://www.aaii.com and at http://www.rothira.com.
After five years and age 591/2 or upon death, disability or special circumstances. Cf. IRC Sec. 408A(d)(2).
IRC Sec.408A(c)(5).
For example, Quicken Financial Planner v 2.0 and T. Rowe Price's IRA Analyzer v 1.0.
This strategy neglects the modest benefits of tax deferral past the second death.
See the instructions for IRS Forms 1040-ES and 2210.
IRC Sec.408A(d)(2)(B)(ii). The holding period is to the end of the fifth tax year, not for five years.
IRC Sec.408A(d)(1)(B).
HR 2676, adopted July 22, 1998. The text of this legislation is available at http://thomas.loc.gov.
Goldberg, S., "How to Pay Less Tax on Your Retirement Savings," 2nd edition, Macmillan, 1997.
IRS Model Roth Agreement. Cf. http://www.rothira.com.
Proposed IRS Regulation Sec.1.401(a)(9)-1, example D-2A.
A $50,000 IRA at age 40 grows to a $400,000 IRA at age 62, assuming a 10% pre-tax return. An extra $400,000 in conversion income at age 62 is likely to be taxed in the 34%, or higher, federal tax bracket whereas an extra $50,000 in conversion income at age 40 might fall within the 28% federal tax bracket.
See the examples in reference 1.
HR 2676, adopted July 22, 1998. This change does not, as yet, apply to California income tax.
Taxpayers filing a separate return may not convert; cf. IRC Sec. 408A(c)(3)(B). Income is calculated in a way similar to determining eligibility for an IRA deduction and the conversion income itself is not considered; cf., IRC Sec. 408A(c)(3)(C)(i).
IRC Sec. 408(d)(3)(A)(i).
IRC Sec. 408A(e)
IRC Sec. 408A(d)(3)(A)(iii). HR 2676, adopted July 22, 1998, makes income averaging optional.

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This article is not a complete discussion of the issues nor is it a full recitation of state and federal tax laws and regulations. Review your personal circumstances with your tax adviser before contributing or converting to a Roth IRA.

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