Should You Rollover to a Roth IRA?

1. Introduction

The Taxpayer Relief Act of 1997 created a new type of individual retirement account (i.e. an IRA) called the Roth IRA. Individuals can only start making contributions to a Roth IRA in 1998.

The key benefits of a Roth IRA, as compared to a regular IRA, are that:

Any future distributions (including, most importantly, distributions of earnings) are tax free;
The IRA owner doesn't have to start taking distributions when he or she reaches age 70-1/2; and
An individual can continue to make contributions to a Roth IRA after age 70-1/2.

The key drawbacks are that contributions to a Roth IRA are always nondeductible, conversions from a regular IRA are currently taxable and qualified distributions cannot be made until 5 tax years have elapsed.

The Roth IRA has rules with regards to the eligibility of making contributions, the maximum amount that can be contributed, rollovers from regular IRAs and the conditions that must be met for distributions to be tax-free.

In this issue we will discuss and give examples on how to determine whether you should roll over (or convert) a regular IRA to a Roth IRA.

2. Planning Whether to Convert to a Roth IRA

If your AGI does not exceed $100,000, then and only then, are you allowed to roll over funds from your regular IRAs to Roth IRAs. Unlike the usual IRA rollover, however, this rollover or conversion is not income tax free. Rather, it is treated as a distribution from the regular IRA, taxable to the same extent as if it had been distributed and not rolled over into another IRA.

Despite being taxable, the distribution is not subject to the 10% premature distribution tax that generally applies to early distributions from a regular IRA if the rollover meets the requirements for a qualified rollover contribution.

Although accelerating the recognition of income usually isn't a desired tax planning goal, for some of you, the current tax cost of converting a regular-IRA to a Roth-IRA may be worth paying.

3. Factors Favoring Rollovers

The following factors favor rolling over or converting non-Roth IRAs to Roth IRAs despite the fact that you will have to pay the tax:

a. The regular IRA has been open for a relatively short period of time, and a large part of the amount in it is from nondeductible contributions.

Example #1

Jane has been making $2,000 nondeductible IRA contributions annually for the past 6 years and has earned 12% per year on the contributions.

At the beginning of 1998, she has an IRA balance of $16,884. Since Jane has a $12,000 basis in her IRA, she will realize only $4,884 of income on a rollover or conversion of the full amount to a Roth IRA.

If the rollover is made in 1998, she will have to include only $1,221 in income for 1998 and each of the following three years. In the 28% bracket, Jane's income tax liability would be increased by $342 in each of those years.

If Jane is 35 years old when she converts to a Roth IRA in 1998, pays the tax resulting from the conversion out of non-IRA funds, and continues to earn 12% annually in the Roth IRA until age 65, she will have an account balance of close to $500,000 from which she can make tax-free withdrawals to supplement her social security and other retirement income.

b. You will not need to take distributions from your IRA at retirement and you want to pass as much as possible to your heirs.

Because amounts in a Roth IRA aren't subject to the required distribution rules at age 70-1/2, taxpayers with Roth IRAs can let their balances continue to build tax-free until death, when their beneficiaries will be able to receive the increased balance free of income tax.

Taxpayers with regular IRAs must take required distributions over their (and their designated beneficiaries) lives or life expectancies, thereby cutting short the tax-deferred buildup within their accounts.

c. You have funds other than IRA funds from which to pay the income tax resulting from the rollover.

d. You do not expect to be in a lower tax bracket when you eventually start taking IRA distributions.

4. Factors Against Rollovers

Factors that weigh against making a rollover or conversion from a non-Roth IRA to a Roth IRA are:

a. You may have to make withdrawals from the Roth IRA that aren't qualified distributions; thus, losing the benefit of tax-free earnings to the extent the distribution exceeds the original rolled over or converted amount.

b. You have a relatively short time to retirement and will need to make withdrawals from your IRA when you retire even though you will be under age 70-1/2 at that time.

c. You expect to be in a significantly lower tax bracket when withdrawals commence than you are in now when the income from the rollover distribution will be taxed.

d. You do not have funds other than IRA funds available to pay the tax resulting from the rollover or conversion to a Roth IRA.

5. Considerations

Figuring whether or not to make a non-Roth to Roth IRA rollover requires some predictions to be made about your future personal and financial status, and deciding whether the potential rewards are worth the potential risk of not being “right” about future developments.

Predicting one's future income tax rate is one of the great uncertainties in this decision-making process. While some individuals may be able to predict their future income with reasonable certainty, it's more difficult to predict the rate at which income may be taxed a number of years into the future.

Lower income taxes in the future would generally make it less likely that you would benefit from making a qualified rollover contribution to a Roth IRA from a regular IRA now. Higher taxes in the future would make it more likely that you would benefit.

Example #2

Jane is in the 28% marginal tax bracket for 1998 and has an IRA consisting exclusively of deductible contributions and earnings on those contributions. In January, 1998, she withdraws $10,000 from her IRA and within 60 days, rolls it over into a Roth IRA. Her AGI for 1998 is $80,000.

Assume the following facts: Either type of IRA grows at a 10% rate annually; Jane is in the 28% tax bracket throughout the period that her money is in the IRA; she has $2,800 in a taxable account that she can tap to pay the extra tax created by the rollover; and the taxable account grows at an after-tax rate of 7.2%.

After 20 years: If she goes the rollover route, and closes out the Roth-IRA after 20 years when she is over age 59-1/2, she will wind up with $68,358. The Roth IRA will grow to $67,275 after 20 years and will be paid out tax-free. Thanks to the four-year spread of income for 1998 rollovers, Jane also will have $1,083 left in the taxable account (which had a balance of $2,800 in January of 1998, and was depleted at the rate of $700 a year for four years to pay the tax bill on the rollover).

By contrast, if Jane leaves her money in the regular IRA and withdraws the balance after 20 years, she will be left with $59,685. That's the $48,438 that would be left of the IRA after paying tax at a rate of 28% on a total distribution of $67,275, plus the $11,247 that she'd have in her taxable account if the $2,800 had not been paid out in taxes for 1998 through 2001. On our facts, Jane would be $8,673 ahead with the rollover, roughly 14-1/2% more than she'd have if the regular IRA were left undisturbed.

After 10 years: The rollover to a Roth IRA would still yield more after 10 years than the regular IRA, but the advantage would be narrower. On our facts, Jane would wind up with about 9% more by rolling her money over to the Roth IRA.

Example #3

Assume the same facts as in the previous example, except that Jane closes out the Roth IRA after ten years after attaining age 59-1/2, and is in the 15% tax bracket at that time.

If she makes the regular-IRA-to-Roth-IRA rollover, she will be left with $26,477. That's the $25,937 tax-free payout from the Roth IRA, plus the $540 that she'll have left in the taxable account after depleting it at the rate of $700 a year for four years to pay the tax bill for the rollover.

If Jane had left the $10,000 in the regular IRA, she would have $27,658 after taxes. That consists of $22,046 from the IRA, after paying a 15% tax on the $25,937 distribution, plus the $5,612 that she'd have in her taxable account had the $2,800 in it not been paid out in taxes for 1998 through 2001. By sticking with the regular IRA, Jane would be $1,721 ahead of where she'd be with the rollover to the Roth IRA.

The situations in the two immediately preceding examples are based on the assumption that the amount of tax on the rollover distributions will be paid out of funds other than the distribution itself, and that the full amount in the IRA will be distributed at once.

If the funds to pay the taxes on a rollover distribution were paid out of the distributed amount, this would reduce the amount that can be built up tax free in the Roth IRA and make it less likely that the rollover would be beneficial.

Example #4

Jane, a single taxpayer, has $60,000 in a regular IRA, all of which would be taxable if she rolled it over to a Roth IRA in 1998. If she does roll it over, she will have to pay any taxes due out of the IRA funds, and the taxes will be 28% of the amounts includible in income ($15,000) in 1998, 1999, 2000 and 2001.

She expects to retire in 10 years, and in her initial years after retirement expects to need at least $9,000 a year after taxes from the IRA. She expects to be in a 15% tax bracket, and expects her investments in the IRA to earn 10% a year compounded annually (regardless of the type of IRA).

If she rolls over the entire $60,000 into a Roth IRA, she will have to pay taxes of $4,200 for each of 1998, 1999, 2000, and 2001, by withdrawing funds from the IRA. Due to the 10% early withdrawal penalties, Jane would have only about $112,500 in her Roth IRA when she retires in 10 years.

If she does not make the rollover, she will have about $155,000 in the non-Roth IRA when she retires. To get the $9,000 after taxes she needs to live on, she will need to withdraw $9,000 from the Roth IRA (or 8% of the amount in the Roth IRA at the time she retires). To get $9,000 out of the regular IRA, she will have to withdraw almost $10,600 (or about 6.8% of the amount in the regular IRA when she retires).

The regular IRA will continue to increase in value at a greater rate after Jane retires since the amount that has to be withdrawn for her to live on is a smaller percentage of the total amount in the regular IRA than the amount that would have to be withdrawn from the Roth IRA is of the total amount in that IRA.

On the other hand, if Jane is in a 28% tax bracket when she retires, she will have to withdraw $12,500 from the regular IRA to get the $9,000 after taxes that she needs. This is 8% of the amount in the regular IRA when she retires. This means that the Roth IRA will increase at the same rate as the regular IRA since in either case 8% of the amount in either IRA will have to be withdrawn to generate the needed $9,000.

However, depending upon the rate of earnings in Jane's non-Roth IRA and the age of her designated beneficiary, if any, the required distribution rules could require her to distribute more than the amount she would otherwise need after age 70-1/2. In that event, she would lose tax-deferred buildup in the non-Roth IRA at a greater rate than with the Roth IRA, giving the Roth IRA an edge at that point.

In determining whether to make a Roth IRA rollover or conversion, there are some additional tax issues for you to consider if you will be receiving social security benefits in the year of conversion.

That's because the income from the rollover/conversion could trigger taxation of your social security benefits, or cause more of your social security benefits to be subject to tax. This consideration generally won't affect taxpayers whose social security benefits are already taxable to the fullest possible extent.

Conversely, taxpayers with IRAs who expect to be subject to social security benefits taxation may find that converting to a Roth IRA now would decrease or eliminate that extra tax in future years.

In conclusion, if you are a long ways away from needing to draw from your IRA or if you are in a position such that you will not need to draw from your IRA at all, then a Roth IRA conversion is a great deal.

However, if you will need your IRA funds in retirement and that is not too long from now then you better do some homework.

Practically every stock brokerage firm has a Roth IRA analysis program to help you do a “what if” analysis pertaining to your specific facts, circumstances and assumptions. We highly recommend that you take advantage of these programs to gain insight as to how tax- free compounding compares to tax-deferred. Good luck.

RealTax professionals have the competence and experience to help you decide if you should rollover to a Roth IRA. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.