Question: My wife and I are both 65 and I have about $500,000 in my IRA account. We have been wondering if we should convert my IRA to a Roth IRA. There are so many things to consider, and it is confusing. What do you suggest?
Answer: In 2010 Congress removed the restriction that prevented IRA owners with incomes higher than $100,000 from converting their IRAs to Roth IRAs. Congress knew that IRA owners with high incomes were in high tax brackets, and allowing conversions might increase tax revenue.
Ask Your Tax Professional
Ask your tax professional for an estimate on how much a conversion will cost you in taxes. It’s been my experience that once an IRA owner is confronted with the large tax bill to convert, even if converting makes financial sense, he or she will choose not to write the check.
In your case, for example, converting to a Roth could cost you $200,000 or more in state and federal income taxes, depending on your marginal tax rates. You would have to pay that tax with money from outside of your IRA, because it wouldn’t make financial sense to use IRA money. Given the choice of keeping $200,000 and a traditional IRA or giving up the $200,000 to have a Roth IRA, could you write that $200,000 check to the IRS?
Writing the check, of course, is just a psychological barrier. Projecting your situation over your life expectancy, it makes financial sense -- to the tune of over $100,000 -- to convert if you don’t plan to spend the money in your IRA. If you do plan to spend the IRA money, then at your age you probably shouldn’t convert.
Despite the “writing a check to the IRS” obstacle, there are times when an IRA owner should convert. Taxpayers with large IRA accounts and estates that will be subject to estate tax when they die can significantly reduce the size of their estate by converting to a Roth and paying income tax now. They will not only reduce the estate tax but they will also remove all the income tax the beneficiaries would have had to pay on the IRA because Roth IRA distributions are tax-free.
Younger IRA owners who don’t need the IRA money until retirement could also benefit by converting, especially if they expect high tax rates during retirement.
Taxpayers who don’t want to take forced distributions from their IRA accounts after age 70 ½ (seventy and one-half) can avoid those required minimum distributions if they convert to a Roth. Once they convert, distributions from the Roth IRA are not required, and if taken, not taxable. In the year they convert, their tax bracket will be high, but in subsequent years they will have better control over their tax bracket and might be able to keep their annual income low enough to avoid paying tax on their social security income and avoid paying higher Medicare Part B premiums.
As you can see, the decision to convert is not cut and dry, especially because of the speculative assumptions you must make about life expectancy, future tax rates, and future spending needs. The IRS also permits you to undo your conversion if you change your mind. More about that next week.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.