Roth Conversions Take Off

Roth Conversions Take Off

Richard Rubin and Margaret Collins at Bloomberg News recently reported that conversions from traditional IRAs to Roth IRAs increased more than nine times in 2010, according to the Internal Revenue Service.  Taxpayers converted $64.8 billion in 2010, as compared to $6.8 billion in 2009. This was the first year that Roth conversions were greater than contributions.  Of course, the primary driver was the elimination that year of the income limit on Roth conversions, not to mention the additional sweetener allowing taxpayers to spread the taxes on the conversions over two years.  Although the latter only applied to Roth conversions taken in 2010, I would expect the number to continue to climb for a number of reasons.

The whole point of a Roth conversion is to convert savings that will be taxable at retirement into savings that will be tax-free.  You pay the taxes on the converted amount now and for the rest of your life those savings together with any earnings remain 100% yours.  That’s a very compelling argument and with the government removing all barriers it’s inevitable that many taxpayers would take advantage.  However, it only makes sense if you expect to be paying less in taxes today than you would in the future.  Bloomberg reported that conversions were especially common among IRA holders with annual incomes exceeding $1 million.  It’s questionable whether the 35% tax they paid on their conversions (the top tax bracket in 2010) is going to be much lower than the tax they would have had to pay on required minimum distributions from their tax-deferred IRAs beginning at age 71.  The point here is that a Roth conversion is not necessarily right for everyone.  It takes a financial analysis to figure out what’s best for you.

Roth conversions are also very beneficial for estate planning.  Not only is a Roth tax-free for the rest of your life, it remains tax free for the remainder of your beneficiaries’ lives as well.  By converting money from an IRA into a Roth, you are paying the taxes for your heirs and ensuring that they will receive 100% of the money after you are gone.  That’s another reason why conversions have become so popular.

What impact do Roth conversions have on government revenue?   When Congress passed the law, the Joint Committee on Taxation estimated that it would raise $6.4 billion for the U.S. government over the first ten years.  To a U.S. Treasury that had been clobbered by revenue losses stemming from the Great Recession, it probably sounded like a win.  However, the Tax Policy Center estimated that the break would actually cost the government $15 billion in revenue over the long run.

In 2013 only about 16% of U.S. households had Roth IRAs, while almost 40% held traditional IRA accounts, according to the Investment Company Institute.  That’s because Roth IRAs are newer – they were first available in 1998 – and because income limits prevent many taxpayers from contributing to Roths.  If you currently have an IRA, it pays to at least consider a Roth conversion each year.  Although the best years tend to be those between your retirement, when your income drops, and age 71, when required minimum distributions kick in, your personal tax situation will dictate when a conversion makes sense for you.  After all, if it’s a money loser for the Treasury, it ought to be good for taxpayers.

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