Roth IRA Conversion?

[Guest Mona]

Please help out one confused person. These are the particulars:

I am 48 and single. My 2004 income will be below $95,000, albeit I do not know what "modified AGI" means. I have four retirement accounts. One is an old traditional deductible IRA at Vanguard that currently has a value of approximately $100,000. The second is a non-deductible IRA with Schwab with a current value of approximately $42,000. The third is an old IRA Rollover (from a past employers 401k) with a current value of approximately $295,000. The fourth is a current Keogh PSP with a current value of approximately $225,000. These assets are approximately 45% of my total financial assets.

I have a few questions. Which accounts can I convert to a Roth IRA so not to pay taxes on withdrawl at retirement? Should I convert the accounts I can to a Roth? If so, should I do so now or wait until the end of 2004? With income below $95,000 in 2004, can I open a Roth (in the recent past I did a non-deductible IRA) and at the same time contribute to my Keogh PSP? Thank you very much.

[John G]

A complex set of questions. I will address only a few areas and leave the rest for the sharp accountants and tax professionals. (Your assets put you in a very solid financial position. Congratulations)

"Which accounts can I convert to a Roth IRA so not to pay taxes on withdrawl at retirement?"

Some clarifications: Any account that can be converted to a Roth will be treated as a Roth where withdrawals are not currently taxed. However, the amount converted will be subject to taxes in the year it is converted. The exact amount subject to taxes will depend upon the mix of deductable, non-deductable and investment earnings in the combination of all IRAs that you own. You don't control the math by picking and choosing to convert from only certain accounts.

Should you convert? This is an extremely complex question. There is nothing magical about a Roth conversion - it can often be a "wash" because you future taxes are offset by conversion year taxes. However, sometimes a partial conversion makes more sense than a full conversion. Your sizeable assets are likely to grow into multiple millions before you reach your mid-60s. You did not indicate when you are expecting to retire, your current income/tax rate, your state of residency, your possible life expectancy, etc. It seems likely that you have non-retirement assets that can be used to pay Roth conversion taxes, but that is an assumption on my part. A Roth conversion looks better if you currently live in a state that has no income taxes, but may retire to a state that does. The conversion question is made more complicated because you have to make assumptions about future rules and tax rates. It is wise to run the numbers now when you might qualify.

You conversion mathematics are likely to be complicated and the size of the assets are significant - therefore you should seek the advice of an accountant or tax professional BEFORE you take any action.

Because I am travelling, I can't elaborate further. Your questions are good and your specific facts and circumstances will likely dictate the best path.

[Guest Mona]

Thanks much for your quick post. Some follow-up questions and clarification:

"Which accounts can I convert to a Roth IRA so not to pay taxes on withdrawl at retirement?"

I follow you that the amount converted will be subject to taxes in the year converted and the complex basis on the tax. However, theoretically can all four retirement accounts be converted to a Roth IRA? Since I have one deductible IRA and one that was non-deductable, should one be converted before the other?

"Should you convert"

When you say "partial conversion", is this the same as saying one of the accounts of some of the money in one of the accounts? While it certainly is a wild guess, possibly I will retire at 60. I do not know my current tax rate but figure my 2004 income will be approximately $90,000. I paid off my home so do have have a mortgage tax deduction, but with other deductions I figure my "taxable income" (line 40 of 2003 return) will be approximately $65,000. Hopefully I will stay healthy and live to late 80's. I reside in the state og PA. (2.9% state tax) but do not see myself staying here until retirement. I am completely flexible, thinking more and more of Florida (no state income tax) and Costa Rica crosses my mind quite often. I do have the non-retirement assets to pay Roth IRA conversion taxes. I am no economist, however, it seems to me income taxes will be higher in the future. That or a reduction in government spending and I'd bet on the former. The one caveat is I am thinking of taking a good part of 2005 off to help some people in Costa Rica. In that case my income in 2005 will be lower than 2004 and possibly a better time to convert.

I see you are traveling and hopefully you or another knowledgeable person will find the time to respond based on the above. Thanks.

[Lame Duck]

since John G. is traveling, I'll see if I can help answer some of your subsequent questions.

1. All of your IRA accounts (deductible, non-deductible, and rollover) can be converted to a Roth. If you are still participating in the keogh plan, that could not be converted until you are eligible to receive a distribution under the plan and first roll it into a traditional IRA.

2. A partial conversion can be all of the assets in one of the accounts, some of the assets in all of the accounts or some of the assets in one account. What you convert and how much you convert is dependent on your tax situation and where the money is coming from to pay the taxes on the converted amount. Of course, the contributions to the non-deductible account have already been taxed so converting that account will result in less tax liability, since only the gains would be taxable in the conversion. In order to have a lower tax bite, you might want to convert your accounts over a period of years, however, you can only convert in years in which your modified adjusted gross income is more than $100,000.

3. The earlier the retirement age, the less valuable the conversion, since the account has less time to recoup the amount paid in taxes, if you are paying the taxes out of the distributable amounts.

There are a number of Roth conversion calculators available on line that you may wish to look at before you make your decision to convert. However, I will also reiterate what John said - you should discuss the conversion with your tax advisor before you make any decisons.

[jevd]

When it comes to determining the taxable amount of the conversion, it doesn't matter which account is used as the IRS considers all traditional IRAs as one. See form 8606 and its instructions.

[Guest Mona]

Lame Duck, thanks for your post. I now have a better understanding. Under your point 2, last sentence, did you mean to say "less" than $100,000?

[Guest Mona]

jevd, thanks. Is this to say it is not correct that since the contributions to the non-deductible account have already taxed, converting this account will result in less tax liability (only the gains would be taxable)? I ask for this clarification because my non-deductible IRA is the smallest of the four, has the least amount of gain and consequently if it advantageous to convert to a Roth IRA, this would result in the least tax liability.

[Lame Duck]

Mona,

what I meant to say was that you cannot convert if your MAGI is greater than $100,000. sorry for the confusion; poor editing on my part.

[Guest Derelict]

jevd, thanks. Is this to say it is not correct that since the contributions to the non-deductible account have already taxed, converting this account will result in less tax liability (only the gains would be taxable)? I ask for this clarification because my non-deductible IRA is the smallest of the four, has the least amount of gain and consequently if it advantageous to convert to a Roth IRA, this would result in the least tax liability.

It would not make a difference. They would all be taxed the same. Basis recovery occurs across all IRAs regardless if the basis is segregated. See form 8606.

Form:

http://www.irs.gov/pub/irs-pdf/f8606.pdf

Instructions:

http://www.irs.gov/pub/irs-pdf/i8606.pdf

-D

[John G]

I concur with Derelict and Jevd - when doing conversion math, all IRA accounts are treated as if there is just one big account. You can't cherry pick just the already taxed components. Also, you convert dollars even if you move specific assets from one account as part of the conversion.... all the math is done on the dollar value of the assets on the day the conversion occurs.

Partial conversion - I was contrasting partial to a full or complete conversion. A partial conversion may be very attractive because you are controlling the tax impact and you may find that some mix of regular and Roth assets is optimal. For example, a full conversion in one year could boost your marginal tax rate whereas leaving some IRA assets would give you a smaller stream of required distributions which might be taxed at a lower rate. There might be implications to estate planning as well. You might be able to due partial conversions in a couple of years from what you said about income changes. There are some downsides to planning multiple partial conversions including: Congress changes the rules, you don't qualify in subsequent years, your regular IRA account increases substantially in value and conversion becomes more expensive.

Deciding about the benefits of conversion involves making some guesses about your future life, tax policy, investment earnings, your health, etc. While there are "calculators" that you can find at the sister website (www.rothira.com), you should get a tax accountant or preparer familiar with your circumstances involved. As that person to give you the possible downsides. Your current assets are substantial and will continue to grow in the next few decades. You don't spend everything in the first year of retirement... so you will be investing and growing your assets for perhaps 4 decades.

Your point on taxes mirrors my view. My best scenario is that they stay constant. My worse scenario is that state and federal max out at about 50%. It may seem ridiculous to you at this point.... but it is conceivable that your assets might reach $30 million. The "Rule of 72" applied at a 10% compounding for 35 years gives you five doubling periods or 2x, 4x, 8x, 16x and finally 32x. You might be closing in on 4x when you are 62, so you would have more than two decades after retirement when you assets would likely grow beyond your annual needs. Which leads me to the conclusion that while you are crunching the numbers for a Roth conversion, you should also be thinking about estate planning. (the first thing you should do is make sure you have at least a basic will and that you have designated beneficiaries - primary and secondary - on all of your retirement accounts)

You really need to find a local tax pro who is familiar with Roths, conversions, estate taxes and investment projections. You may need to interview three or more people to find someone highly qualified. I spent about $500 when I did my conversions in 1998 and my accountant and I were breaking a lot of new ground to figure out the math. It should be a little easier to find someone with experience today - ask how many conversions they have done, what professional seminars they have attended, the software they use and the estate planning lawyers with whom they work. (maybe some of our accountants can suggest other ways to find professional help)

Your current assets and your "trajectory" are likely to put you in an enviable position of having a wide array of lifestyle choices. When you choose to retire, the throwoff from your assets will probably exceed what you normally spend now. Good luck with your choices.