Rollover IRA to Roth IRA

17 Nov

Rollover IRA to Roth IRA Conversion

Many taxpayers consider the option to rollover their traditional IRA to a Roth IRA in order to convert money that grows tax deferred to tax free. This conversion can produce large tax savings over the long run — over $100,000 in some cases.

                           Roth IRA    Regular IRA
Balance Today              $300,000    $300,000
Balance in 20 years        $962,140    $962,140
Tax Due                           0    $317,506
Add back                               $219,112
Value after tax and
add back                   $962,140    $863,746
Tax Free Growth                YES         NO

Assumptions: IRA owner age 65 grows IRA for 20 years until death.  Mandatory distributions taken from other IRA funds so unencumbered growth occurs in regular IRA.  All funds earn 6%, combined tax rate of 33%.  Roth IRA conversion tax is paid from non-IRA funds.  The “add back” in the above table is the future value of the tax dollars saved (taxes that don’t need to be paid) if the Roth IRA conversion is not done and the regular IRA is retained.

Yet for others, the Roth rollover may not pay. It’s important to understand the following rollover issues before deciding whether to do an IRA to Roth IRA conversion which we cover in this article.

Why Consummate an Rollover IRA to Roth IRA Conversion?

* Your Roth IRA will grow to a larger amount than your regular IRA even if it contains the same number of dollars. The reason is that the Roth IRA contains after-tax dollars. In a traditional IRA, some of the earnings will eventually go to the government in the form of income tax, but in a Roth IRA you get to keep everything. A bigger balance means bigger cash flow in retirement.

* You can keep your money in a Roth IRA for a longer period of time. There is no requirement for minimum distributions to begin when you reach age 70½. Keeping money in an Rollover IRA for a longer period of time means extending the period of tax-free compounding.  Again, a bigger balance means more cash flow in retirement.

* If you’re wealthy enough have a potential estate tax liability, rolling over to a Roth IRA may reduce that liability. If you die holding a regular IRA, the entire IRA may be included in your estate even though part of it will end up going to the IRS as income tax (and estate tax) when your beneficiaries take distributions. In the case of a Roth IRA, you have already paid the income tax, so your estate is smaller even though you are effectively passing the same amount of wealth to your heirs.

There’s a special added benefit if you have a significant amount of basis in your regular IRA — in other words, if you made nondeductible contributions to your regular IRA. When you rollover your regular IRA to a Roth IRA, the portion of the rollover that comes from nondeductible contributions is tax-free, i.e. you pay no tax on these funds as you already paid tax on these after-tax dollars. Yet you are moving that money from a place where the earnings will be taxable eventually to a place where the earnings will be entirely free from tax. You should strongly consider a rollover if you’ve made nondeductible contributions to your regular IRA. Note, however, that you’re not permitted to roll over only the tax-free portion of your regular IRA. Any distribution you take from your regular IRA, including a rollover distribution, comes partly from your nondeductible contributions and partly from other amounts (deductible contributions and earnings) that are in your IRA.

The Big Consideration–The Tax Due Now

The conversion to a Roth IRA so far sounds good but what stops most taxpayers is that they must pay tax on any of the pre-tax dollars rollover to a Roth IRA.  No one likes finding money to pay tax. The important question to ask when considering a rollover to a Roth IRA is: where will you get the money to pay the tax? If you have the money readily available (e.g. in a savings account)— without using any of the money that’s now sitting in your IRA — you’re in good shape to consider a rollover. However, if you don’t have funds to pay the tax and you need to use IRA money to pay taxes on the rollover, the rollover is not for you as you will defeat the benefits. This is a factor indicating that you shouldn’t do the rollover unless you’ve done a thorough analysis and understand the benefits and detriments thoroughly.

Tax Brackets and Partial Conversions

These are the tax brackets for 2010 for married and single taxpayers.

Federal Income Tax Brackets For 2010 – Based On Taxable Income Ranges

Tax Rate Married Filing Jointly  Most Single Filers
10%     Not over $16,750         Not over $8,375
15%     $16,750 – $68,000        $8,375 – $34,000
25%     $68,000 – $137,300       $34,000 – $82,400
28%     $137,300 – $209,250      $82,400 – $171,850
33%     $209,250 – $373,650      $171,850 – $373,650
35%     Over $373,650            Over $373,650

Another important question to ask is how tax brackets will affect the rollover. Try to estimate what tax rate will apply to your IRA when you withdraw the money in retirement or otherwise. If you expect to pay only 15% on most or all of your IRA distributions when you make distributions in retirement, you should avoid paying 25% or more today on your rollover unless it is strongly justified.

If you’re in the 25% tax bracket (or higher) now, and know you’ll be in the 15% bracket when you retire, there’s little you can do about this factor. You may want to consider preparing a detailed projection (or having a tax professional do so) to see if you can still benefit from the rollover. Unless your situation is unusual in some way, you’ll probably find that there’s little or no benefit in making the Roth IRA rollover.

Some people will find that although they’re in the 15% tax bracket now, the rollover itself will push them into a higher  tax bracket making the Roth IRA conversion uneconomical. If this is your situation, you should consider rollover part of your IRA to a Roth IRA. If you convert just a portion each year, this may keep your tax bracket down and minimize your conversion tax.

Case Study

Bill and Linda are both retired, have large IRAs, and are age 60.  Their taxable income will be $30,000 this year.

The tax law extends the 15% tax bracket for married couples filing jointly to $68,000 (see table above).  Thus, Bill and Linda could convert $38,000 worth of their IRAs to Roth IRAs this year and fully use up their 15% tax bracket.

The federal income tax rate on the $38,000 conversion will be 15% ($5,700).  And after Bill and Linda hold the Roth IRAs for five years, they can withdraw the money tax-free.  Each year they will repeat the process and continually shift a large portion of their IRA to a Roth.  By doing partial conversions each year, they never push themselves into a tax bracket higher than 15%.

If Bill and Linda had waited until they were 70 ½ and subject to required minimum distributions, the withdrawals may have pushed them into a higher marginal tax bracket or tax brackets may be higher due to federal deficits.

If retirement is many years away (say, 20 or more) you may choose to make the rollover even if it appears you may be incurring more tax now than you would in retirement. Twenty years is a long time in which to enjoy the benefits of the Roth IRA Rollover–the tax free compounding. If you take full advantage of those benefits by maximizing the amount you keep invested there, your gains may outweigh the tax cost of converting to a Roth IRA.

Finally, as explained above, a rollover to a Roth IRA provides a special bonus if you’ve made nondeductible contributions to your regular IRA. If a significant portion of your regular IRA is from nondeductible contributions you should consider a rollover even if it means paying tax at a higher rate on the portion of the rollover that’s taxable. In this situation, it may be necessary to prepare an income projection (or have one prepared by a tax professional) to determine what choice works out best.

Creditor Protection

Many states provide some measure of creditor protection to regular IRAs (although they aren’t necessarily completely insulated). For reasons having to do with the way state bankruptcy laws are written, there’s some question whether the same protections are available to Roth IRAs. If you have a reason to be concerned about creditor protection — for example, your debts are large or you engage in a high risk business or profession — you should consider this issue before you roll over a large amount from a regular IRA to a Roth IRA. And the issue is even more important if the money you’re planning to rollover to a Roth IRA is currently in an employer plan, protected by federal retirement law (ERISA) which gives you total creditor protection.
Learn more.  Get your free copy “Six Best and Worst IRA Rollover Decisions

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