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Thus, unlike regular IRAs, which only defer taxes, the Roth IRA allows the tax-free accumulation of wealth.

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Conversion to a Roth IRA

Perhaps the most significant feature of the TRA ’97 for taxpayers who have IRA accumulations is the ability under Sec. 408A(d)(3) to convert a regular IRA to a Roth IRA. Although generally, income taxes must be paid on the amount converted at the time of the conversion, Sec. 408A(d)(3)(A)(iii) allows the owner to include the income ratably over four years, if the conversion occurs in 1998.

Example 3: B converts $100,000 from her regular IRA to a new Roth IRA in 1998. In each of 1998, 1999, 2000 and 2001, she will include $25,000 in gross income. If the conversion occurred in 1999 or thereafter, the entire $100,000 would be included in B’s income in the year of conversion.

The Tax Technical Corrections Act of 19972 would impose a 10% penalty on amounts converted from a regular IRA to a Roth IRA that are subsequently withdrawn before the expiration of the four-year income inclusion period. (This is in addition to the 10% penalty imposed on the withdrawal of earnings before the five-year holding period.) If the IRA owner dies before the end of the four-year spread period and named a nonspouse as the beneficiary, the unreported balance must be included as income on the IRA owner’s final return. A spouse named as the beneficiary can continue including the amounts ratably in gross income.

AGI Limits

The conversion strategy has a significant drawback--Sec. 408A(c)(3)(B)(i) provides that a regular IRA can be converted to a Roth IRA only if the owner’s AGI (computed before the conversion) does not exceed $100,000 (whether married or single). Sec. 408A(c)(3)(B)(ii) bars

conversion by married taxpayers filing separately. IRA owners whose AGIs exceed $100,000 should consider tax-planning strategies with the goal of reducing AGI below $100,000 (preferably in 1998) to create a one-year window of opportunity to convert.

Active Participants

Often, active participants have the option at retirement to roll over their plan accumulations into an IRA. In most circumstances, currently employed active participants will not be allowed to roll over their accumulations in employer plans into an IRA. This puts an employee with a significant accumulation in his employer plan in a worse position than one who has an identical balance in an IRA. Many employees, however, may have IRAs as well, that will

will be eligible for conversion before the owner’s retirement or termination.

Factors to Consider

The potential for tax-free growth is so compelling that all taxpayers who have substantial IRA balances and qualify for conversion should consider whether to convert at least a portion of their IRAs. Because the decision contains many variables, clients likely will seek advice from their CPAs in deciding whether the conversion will be beneficial. A Roth IRA conversion is one of the rare situations in which a CPA may recommend prepaying income taxes; however, many factors must be considered, including:

  • The IRA owner’s current and future income tax rates.
  • The IRA owner’s age and life expectancy.
  • The IRA owner’s anticipated spending needs during retirement.
  • The IRA owner’s other sources of retirement funds (including pension plans).
  • The IRA owner’s other sources of after-tax money and investments.
  • The age and life expectancy of the IRA owner’s beneficiary.
  • The beneficiary’s planned use of the IRA funds on inheritance.
  • The beneficiary’s future income tax rates.
  • The rate of return on investment.
Example 4: Balance in IRA Account

Assumptions:

G's (IRA owner's) Current and Future Federal Income Tax Rate 28%
Current and future state income tax rate (state taxes apply to investment
earnings on after-tax funds, but not to retirement plan distributions)		 3%
Income tax rate on additional income generated by the conversion and
taxed in 1998-2001		 31%
G’s age at conversion 55
Beneficiary’s age at conversion (used to calculate life expectancy factors) 53
Withdrawal income tax rate 28%
Regular IRA fund amount converted $100,000
After-tax funds available (used only to pay income taxes) $100,000
Interest earned on invested funds 10%
Method of calculating required minimum distributions Joint lives, recalculated


Balance on G Reaching Age
  56.08 65 75 85 95
Regular IRA:                    
Balance in regular IRA $110,865 $259,374 $531,652 $692,780 $509,096
Balance in after-tax funds 107,480 194,884 475,801 1,361,611 3,460,417
Total assets 218,344 454,258 1,007,453 2,054,391 3,969,513
Income tax on regular IRA (31,042) (72,625) (148,862) (193,978) (142,547)
Net assets $187,302 $381,633 $ 858,591 $1,860,413 $3,826,966
             
Conversion to Roth IRA:           
Balance in Roth IRA $110,865 $259,374 $672,750 $1,744,940 $4,525,926
Balance in after-tax funds 91,937 143,610 279,873 545,429 1,062,956
Total assets 202,802 402,984 952,623 2,290,369 5,588,882
Deferred tax liability (15,500) 0 0 0 0
Net assets $187,302 $402,984 $952,623 $2,290,369 $5,588,882
                 
Roth IRA net assets exceed regular IRA net assets by:   $0 $21,351 $94,032 $429,956 $1,761,916
 
 

 

 

 

 

 

 

 

 

 

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The potential for tax-free growth is so compelling that all taxpayers who have substantial IRA balances and qualify for conversion should consider whether to convert at least a portion of their IRAs.

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Example 4 in the box above demonstrates that a regular-to-Roth IRA conversion will result in greater net assets than if there is no conversion. In this example, net assets are measured in after-tax dollars (i.e., at the different measuring ages, it is assumed that all of the IRA funds are withdrawn and income taxes paid on the withdrawals). Additionally, the conversion occurs in 1998, so the four-year income spread is available.

Example 4 shows the amount that would be inherited by the beneficiary if G (the IRA owner) dies at the stated age and the beneficiary immediately withdraws the entire IRA balance, or the after-tax dollars available to G if he withdraws all funds from the account at the stated age. In the example, G is required to take minimum distributions from his regular IRA at age 70½, which are taxed and added to the after-tax funds balance. Thus, the regular IRA net asset balances are much lower than the Roth IRA balances when G reaches age 75, 85 and 95. Distributions need not be taken from the Roth IRA, allowing for continued tax-free growth. Although the after-tax funds from the Roth IRA are less than the pre-tax funds from the regular IRA, the net combined assets from the Roth IRA exceed that of the regular IRA almost immediately, because the Roth IRA’s earnings are tax-free.

In this example, the benefit of making the conversion occurs 1.08 years after conversion, and continues to grow over time. The conversion is slightly detrimental in the first 1.08 years, because it is assumed that G and his spouse are in the 31% bracket in the conversion year (1998) and the following three years (1999-2001), because of the four-year income inclusion. When G is age 78.9, his Roth IRA’s total assets exceed those in a regular IRA. Comparing total assets, however, is useful only in limited circumstances (e.g., when the beneficiary is a charity). A dollar in a regular IRA is generally worth less than an after-tax dollar, and a dollar in a Roth IRA is worth more than an after-tax dollar because of the continued tax-free growth potential of these funds. The different values of a dollar in the Roth and regular IRAs and after-tax funds could become quite substantial.

Example 4 assumes complete withdrawal of the IRA funds at the stated ages. A more realistic assumption is that G will leave the funds in the Roth IRA until they are needed or desired, and then withdraw only the amount needed, not the entire balance. In general, the longer the funds are invested, the more valuable the Roth IRA becomes compared to either after-tax money or a regular IRA. Because the timeframe used to compare a Roth IRA to a regular IRA could be as long as G’s and the beneficiary’s lives, with only minimum distributions based on the beneficiary’s life expectancy throughout, determining the relative value of a dollar in these different environments is quite complex.

In certain circumstances, a Roth IRA may still be beneficial, even if G did not have sufficient after-tax funds to pay the income taxes due on conversion of a portion of a regular IRA. The remaining, unconverted IRA funds are used to pay the income tax liability on the converted portion. However, the conversion is not as beneficial as when after-tax funds are available to pay the income taxes on the converted funds.

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Other Variables

Effect of Different Income Tax Rates in Retirement

What is the effect of G having a lower or higher income tax rate in retirement?

Example 5: The facts are the same as in Example 4, except that G’s tax bracket changes during retirement. The table below illustrates the difference in net assets after conversion.

Example 5:

G’s tax bracket in retirement (age 66 and up)

Amount by which Roth IRA net assets exceed
Regular IRA Net Assets when G is Age:
    65 75 85 95
15% $21,351 $61,139 $201,872 $853,376
15% ages 66-70, 28% ages 71-95 21,351 87,808 417,824 1,738,271
28% (as in Example 4) 21,351 94,032 429,956 1,761,916
31% 21,351 101,305 477,503 1,939,934
36% 21,351 113,168 552,875 2,213,866
 
 
 

Thus, for a taxpayer in the 28% bracket, converting to a Roth IRA will always be advantageous if the funds are invested for 10 years or more, even if the IRA owner’s tax bracket will decline from 28% at the time of conversion to 15% at retirement. Converting to a Roth IRA will be even more advantageous if the IRA owner’s bracket will increase during retirement.

Effect of Investment Appreciation and Capital Gains on After-Tax Investments

Some critics of the above analysis suggest that it is not realistic to assume that all after-tax investments will generate an increase in value by only the amount of regular income; rather, some of the increase in value will be capital appreciation that is not currently taxed and some will be current capital gain.

Example 6: The facts are the same as in Example 4, except that (1) only 30% of the investment income (e.g., interest and dividends) are taxed at regular rates; (2) capital appreciation occurs on 70% of the investment income; (3) capital gains result each year based on a 15% portfolio turnover rate (i.e.,15% of the beginning year’s cumulative capital appreciation not previously taxed); such gains will be taxed at 18%. In addition, the accumulated after-tax appreciation that has not been taxed may be taxed at a capital gains rate (if the investments are sold) or represent a step-up in basis for heirs (if held until death), completely avoiding taxation.

This example demonstrates that when the investor achieves more favorable capital gains tax treatment on after-tax investments, the advantage of a Roth IRA conversion is mitigated somewhat, but still remains.


Example 6:

After-tax investment income (10% rate of return Amount by which Roth IRA net assets exceed regular IRA net assets when G reaches age:

     

57 65 75 85 95
Regular income tax rates
(as in Example 4)		 $2,345 $21,351 $94,032 $429,956 $1,761,916
Capital gains and appreciation,
capital gains tax paid in last year		 2,275 17,385 71,980 319,130 1,297,430
Capital gains and appreciation,
stepped-up basis after death		 2,177 14,783 63,331 278,128 1,155,100
 

When to Convert

Is it better to convert to a Roth IRA earlier or later?

Example 7: In 1998, Y and Z are each 30 years old; each has a $100,000 regular IRA. Y converts his IRA to a Roth IRA at age 30; Z converts his IRA at age 55. By waiting until age 55, Z will not have the four-year spread period for paying tax on the conversion. The table below illustrates the different results.


Example 7:

   Y

   

Z    
                  
Balances at age 55:           
IRA funds $1,083,471 (Roth) $1,083,471 (Regular)
After-tax funds 390,706    530,204    
Total assets 1,474,177    1,613,675 (Before Conversion)
Income tax on IRA 0    (379,215)    
Net assets $1,474,177    $1,234,460 (After Conversion)
                
Balances at age 70:              
Roth IRA funds $4,525,926   $4,525,927  
After-tax funds 1,062,956   477,374  
Total and net assets $5,588,882   $5,003,301  
 

Making the conversion at a younger age is more beneficial, because the Roth IRA has more time to grow tax-free (as opposed to tax-deferred in a regular IRA). Another advantage of an earlier conversion is that Congress could repeal the ability to convert; however, converted IRAs should be grandfathered.

Inherited Funds

The results in Example 4 can understate the advantages of a Roth IRA, because they do not consider the beneficiary’s timeframe for making distributions from the inherited IRA. The analysis does not consider the potential benefits a beneficiary may receive from withdrawing less than all of the funds immediately after the IRA owner’s death. Tax-free growth is maximized only if the beneficiary takes the required minimum distributions. Decreasing the rate at which distributions are taken from a inherited regular IRA will only defer taxes, while slowing distributions from an inherited Roth IRA will provide greater tax-free growth.

Example 8:  W, age 45, inherits a $100,000 regular IRA. His Federal income tax rate is 28%; his state income tax rate is 3% (on after-tax investment income). All after-tax and IRA funds earn 10% annually. Only required minimum distributions are taken, and they are equal for both the Roth and regular IRA. These distributions are added to the after-tax funds.

Example 8 and Exhibit 3 below clearly illustrate the advantage of inheriting a Roth IRA versus a regular IRA; the difference results from the lack of income tax on the Roth IRA.


Example 8:
   

W's Age
    45 55 70 85
Inherited regular IRA:           
Balance in regular IRA $100,000 $196,068 $403,820 $0
Balance in after-tax funds 0 40,240 356,691 1,947,311
Total assets $100,000 $236,308 $760,511 $1,947,311
Income tax on regular IRA 28,000 54,899 113,070 0
Net assets $ 72,000 $181,409 $647,441 $1,947,311
Inherited Roth IRA:             
Balance in Roth IRA $100,000 $196,068 $403,820 $0
Balance in after-tax funds 0 56,559 510,055 2,832,613
Total and net assets $100,000 $252,627 $913,875 $2,832,613

 

 
 
 
Example 9: The facts are the same as in Example 4, except that G dies at age 75. His total assets at death (assuming he converted to a Roth IRA) are less than if he had not converted. G’s beneficiary spends $48,000 per year (indexed for 4% inflation) of the after-tax funds inherited.


Example 9:

   

Beneficiary’s age at inheritance
    45 55 70 85
Regular IRA:          
Balance in regular IRA $531,652 $1,042,402 $2,146,917 $0
Balance in after-tax funds 475,801 365,585 55,704 1,287,303
Total assets 1,007,453 1,407,987 2,202,621 1,287,303
Tax on regular IRA, if withdrawn (148,863) (291,873) (601,137) 0
Net assets $ 858,590 $1,116,114 $1,601,484 $1,287,303
G Converts to Roth IRA 20 Years Before Death:           
Balance in Roth IRA $672,750 $1,319,051 $2,716,699 $0
Balance in after-tax funds 279,873 145,807 453,364 6,303,362
Total and net assets $952,623 $1,464,858 $3,170,063 $6,303,362

Example 9 demonstrates the long-term implications of tax deferral (i.e., a regular IRA) versus tax-free growth (i.e., a Roth IRA), and the significant advantage that accrues to a beneficiary who inherits a converted Roth IRA.

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Disadvantages of Converting

The most apparent disadvantage of converting to a Roth IRA is that income taxes will have to be paid on conversion. The benefits to be received are long-term and hard to measure. In addition, if the income tax rates for investment income or IRA distributions are reduced or repealed, the advantages shown in the above examples may not be realized. If the Federal income tax system is radically changed (or abolished in favor of a national flat or sales tax), IRA owners who converted could suffer a reduction in funds without an equivalent reduction in taxes. In addition, making the conversion is not advisable if the beneficiary is a charity. Further, differing income tax laws in some states may result in the Roth IRA earnings being taxed as ordinary investment income. Although several states may change their laws to exempt Roth IRA income (and some intend to do so), this could remain a disadvantage in other states. Finally, if an IRA owner’s future tax rate will be significantly lower, converting now at a higher rate may not be as beneficial as waiting until later and converting at a lower rate. Nonetheless, despite all of these potential disadvantages and the uncertainty of the assumptions made, all eligible taxpayers should give serious consideration to converting at least a portion of their regular IRAs to a Roth IRA.

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