Updated January 2016 — A Roth IRA can be a great part of a comprehensive retirement income plan. The potential benefits are substantial: tax-free income in retirement, flexible withdrawal options, no required minimum distributions, and prepaid income for beneficiaries.
However, until 2010, a Roth IRA conversion was off limits to high-income earners. While new Roth IRA contributions are still not allowed for those whose modified adjusted gross income (MAGI) exceeds $193,000 for married couples filing jointly or $131,000 for single taxpayers (for 2015), now there is a way for high earners to tap into these benefits through a Roth IRA conversion strategy.
With this option, as with any retirement planning strategy, there are important considerations. Bryan Austin, CFP®, CIMA®, Director of Financial Planning with Abbot Downing, and Tracie McMillion, Senior Vice President – Head of Global Asset Allocation for the Wells Fargo Investment Institute, discuss the basics of these Roth IRA conversions and how they may be used to help make the most of an overall financial plan.
Roth IRA conversion strategy: How and why
The process for these conversions is fairly straightforward. "For 2016, high-income taxpayers may make a nondeductible, Traditional IRA contribution of $5,500 ($6,500 if they are over age 50)," Austin explains. "The taxpayer may later convert the Traditional IRA into a Roth IRA."
You can convert after age 70, but your required minimum distribution must first be satisfied. However, you cannot make contributions to a Traditional IRA after age 70, McMillion notes. And, she adds, "This works best if you do not have existing before-tax IRA assets" in any of your Traditional, SEP, and SIMPLE IRAs.
Why is the ability to use a Roth IRA as part of an overall retirement plan such a valuable opportunity? "The two main benefits to Roth IRAs for high earners are potential income tax mitigation and reducing the impact of the Medicare surtax on unearned investment income," says Austin.
Contributions to a Roth IRA, because they have already been taxed, can be withdrawn at any time without taxes or penalties. But earnings from a Roth account can also be distributed income-tax-free as long as the account has been in existence for five years and certain conditions are met, says Austin. Some of the conditions are meeting the age limit of 59 1/2, having a disability, being a first-time homebuyer, or death of the owner.
Austin also points out the benefits of a Roth IRA in light of the Medicare surtax that is part of the Affordable Care Act. The 3.8 percent Medicare surtax is assessed on investment income if MAGI exceeds $200,000 (single) or $250,000 (joint filers). "An increase in MAGI could subject investment income to a tax that may otherwise not be payable," he says. "Distributions from a Roth IRA do not increase the account owner's MAGI for purposes of the Medicare surtax."
Before you convert
Both Austin and McMillion caution that it's important to talk with a tax professional to see if a Roth IRA conversion is the right move. "This is a straightforward conversion for those who do not have existing Traditional, SEP, or SIMPLE IRAs or have only nondeductible contributions," says McMillion. "If you have deductible contributions, then the pro rata rule will apply to your conversion."
The pro rata rule is often referred to as the "cream-in-your-coffee" rule. Once the cream and coffee are combined, you cannot separate them; in the same way, blending before-tax and after-tax funds in any Traditional, SEP, or SIMPLE IRA(s) cannot be separated. This is true even if you keep the before-tax amounts in a different IRA from the after-tax amounts, as the values of all SEP, SIMPLE, and/or Traditional IRA(s) are combined for purposes of determining the percentage of any distribution or conversion that is taxed.
"The two main benefits to Roth IRAs for high earners are potential income tax mitigation and reducing the impact of the Medicare surtax." — Bryan Austin, Abbot Downing
And those who already have Traditional IRAs with deductible assets must remember that taxpayers cannot choose which IRA they wish to convert. "If a conversion is made, the tax-free portion of the conversion is based on a fraction," says Austin. "The numerator is your nondeductible contributions and the denominator is the total balance of all of your Traditional, SEP, and SIMPLE IRAs. The remaining portion will be taxed at your ordinary income tax rates."
So, for example, take the case of a taxpayer who makes nondeductible contributions of $5,500 to a Traditional IRA, and then converts it to a Roth IRA. If this taxpayer has no other IRA assets, there is generally no tax owed on such a conversion.
However, say this taxpayer has another Traditional IRA with deductible contributions totaling $100,000. The IRS counts all IRAs together, so that taxpayer's total IRA funds are $105,500. The nontaxable portion of that $5,500 conversion is determined by first multiplying the conversion amount by a fraction equal to the conversion amount divided by total assets. So, $5,500 X $5,500/$105,500, which equals $287. That amount is the nontaxable portion, while the rest of that $5,500 conversion, $5,213, would be subject to taxes. A Roth conversion may not be the best option in this case.
Remember you must also include all distributions, including conversions and any outstanding rollovers in that balance. And do note that any calculations done prior to the end of the distribution year may not reflect the actual tax-free portion. This is because the calculation is based on the value of your IRAs on December 31.
McMillion also recommends looking at current versus future tax rates. Taxpayers who think they may have lower tax rates at retirement may want to opt for deductible contributions to a 401(k) retirement fund or a Traditional IRA (if they qualify). "Also, the timing of the conversion is important," she says. "If you are younger and have many years for your Roth IRA assets to grow, a conversion may be an attractive option even if it creates a taxable event today." For individuals who are already retired, she adds, a Roth conversion may not make as much sense, especially if the Roth will go to heirs who are in a lower tax bracket or if the IRA will be left to a charity.
Austin also points out that any taxes that may need to be paid on a conversion should be paid with funds outside the IRA. If this isn't possible, or if the taxpayer needs the distributions for retirement cash flow, a Roth conversion may not be the most effective option.
And, "another consideration is that Roth IRA tax policy may change at some point in the future, requiring you to rethink your retirement income plans," says McMillion.
Austin agrees. "Taxpayers should always consult with their professional advisors before proceeding with a Roth conversion to determine whether this makes sense for their given situation," he says.