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Roth Conversions: A Legacy Enhancer for the Wealthy

Last updated 2 years ago

By: Steven E. Monacelli, CPA/PFS, MST

All this hype about Roth Conversion opportunities appears to add excitement to the tool box of many financial planners. The hype was created by a tax law change effective in 2010 whereby individuals with adjusted gross incomes in excess of $100,000 were allowed to convert a regular IRA to a Roth IRA. Beginning in 2011 and beyond, there is no limit on adjusted gross income to qualify to convert an IRA to a Roth IRA. But don’t jump just yet… most accountants and tax planners are of the mindset to defer the recognition of income to a later day. The attractiveness of tax free earnings in the future can only be achieved by paying tax today on ordinary income in the amount that you elect to convert to a Roth. The following articulates the perfect scenario by which a Roth Conversion begins to make sense.

  • You are paying the tax on the Roth conversion outside of the amount you are converting to a Roth IRA.
  • You expect tax rates to remain stable or increase in your future retirement years. To the extent rates increase, a conversion today may be more favorable. To the extent rates decrease, a conversion today may not seem as attractive. Bear in mind that your domicile counts! If you are planning a move from a State whereby a high tax rate exists to a State where a lower rate or no rate exists such as Florida, this domicile change matters in the consideration.
  • You expect to not have to use your retirement funds for your living expenses in your retirement. If your non-retirement portfolio will support your lifestyle in your retirement, your money will have more time to grow tax free. Please note that required minimum distributions do not apply to Roth IRA’s.
  • Younger is more favorable than older since you will have more opportunity for the money to grow tax free.
  • The second generation…If you have children who will inherit your Roth IRA account, they too will enjoy the benefit of tax free growth of earnings. However, the inherited Roth accounts must be distributed over the life expectancy of the beneficiaries. Not because the Treasury is taxing the accounts but because the Treasury wants to remove the funds from the tax free bucket of earnings.
  • Action item:    The second generation will have a great opportunity to grow the account tax free and take distributions over their lives tax free. Some States including Rhode Island exclude inherited and gifted assets from marital estates. We all know what happens in a future divorce. Educate your children to protect their assets in the event of a divorce. If your children take their required distributions and directly fund an account in their sole names, a divorce in Rhode Island will not result in kissing half of this money goodbye.
  • One other variable that will upset legacy wealth planning is a major purchase by a child who is seeking to “invest” in non-income producing property for personal consumption…the Ferrari that looks good in the new car showroom. Looking for a way to generate funds to pay for items that will not appreciate, the child may opt to pay no tax and take the money from the Roth IRA. Wow…a real planning upset. It is not all in one family from the mid-west…

As one can see, there are too many variables to predict intended outcomes with great certainty. Why not hedge your financial bet with a conversion of half if you think it is right for you? If you do convert some or all of your IRA account, you can “take a mulligan” by the end of the year by converting back to your IRA account. This action will undo any tax consequences of a Roth conversion if you should change your mind or if the market drops…undo the transaction, wait 30 days, and re-convert to a Roth account at a lower value which will produce a lower tax cost for the transaction. Just a reminder, you should consult your financial advisors on these matters. Don’t be afraid to ask what might appear to be stupid questions to some…after all, it is your money.

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