2012 Might Be Your Last Best Chance
Good news! If you're wealthy enough that you won't be depending on your IRA assets for retirement income, and you expect your income tax rate in retirement to be equal or higher than it is now, you'll most likely save a fortune in taxes for yourself or your descendants if you convert your IRA to a Roth IRA, especially if you do it before the fast approaching end of 2012.
What is a Roth IRA conversion?
Taking a step back, a Traditional IRA is generally funded with pre-tax contributions, growth of the IRA is tax free, and then income taxes are paid on distributions at top personal marginal tax rates. Additionally, once someone hits 70.5 years old, required minimum distributions force money out of the IRA each year in increasing larger percentages. If you're lucky enough to live to 100, the booby prize is that your IRA will be decimated and you or your heirs will be left with a lousy pile of non-IRA money that doesn't get to grow tax free.
A Roth IRA is different, though growth is still free of capital gains taxes, all funding of the account is done with after-tax dollars, and, most importantly, no income taxes are paid on the distributions. There are also no required minimum distributions unless the Roth is inherited. These differences might not sound like much, but the implications for wealth protection and estate planning are huge.
In a Roth IRA conversion, for the privilege of moving your IRA assets into a Roth IRA, you pay income tax on the amount of the conversion using cash from outside the IRA. How on earth is paying taxes now versus later a good idea? Let me walk you through the math.
How will I have more money in the end by paying conversion taxes now? Let's assume you have a $1,000,000 IRA. Please keep in mind, before the Roth conversion this million dollar IRA does not represent an extra $1,000,000 to your net worth. An IRA is only ever worth its after-tax value, which in the following example is $560,000. Now let's convert it to a Roth IRA, and let's use the current roughly 44% combined effective top income tax rate for Californians (35% Federal plus 13.3% CA (prop 30 is retroactive in 2012) with state tax deductions) and a 35% investment earnings tax rate (because some gains are long term, some are short term, and some are from dividends and interest. When you convert your IRA, you'd pay $440,000 in taxes from a cash account. From there, your $1,000,000 Roth IRA would grow tax free, distributions from the Roth would be tax free, but you'd miss out on the growth of the $440,000 non-IRA money. The key is that the $440,000 would have been growing with the headwind of investment earnings taxes.
Let's say you're 50 years old when you make the conversion, and your yearly pre-tax investment return is 5% per year. Over the next 20 years the $1,000,000 would grow to $2,653,297. The $440,000 cash, on the other hand, would not have grown at 5% per year, it would only grow at 3.25% per year due to the 35% investment earnings tax rate headwind. After 20 years, this cash would only have been worth $834,168. Subtracting this from the 20-year Roth value yields a post-Roth conversion after-tax value of $1,819,129. A 20-year total return of 225% on your original $560,000.
Now let's compare that to leaving the IRA alone for 20 years. Like the Roth, the IRA would grow tax free for 20 years and have a pre-tax face value of $2,653,297, but, regrettably, any dollar you take out at that point will be taxed at full income tax rates. Assuming tax rates are "back down" to 44% in 20 years, the after-tax value of your IRA would only be $1,485,846 - that's $333,282 less than if you had made the Roth Conversion when you were 50, and a total return of 165% versus 225%!
What if I'm already 70?
The benefits of the Roth Conversion actually increase once required minimum distributions start. Say you have $1,000,000 in an IRA at age 70, looking at 20 years of growth the math on the Roth side is unchanged from our previous example, the Roth would be worth an after tax $1,819,129.
The huge difference is on the IRA side. Required Minimum Distributions will begin to remove money from your IRA each year in increasingly large amounts. The best you can do with this RMD cash is invest it at the growth rate of your taxable accounts. Over time as the RMDs take money out of your IRA year after year, a smaller share of your net worth will be able to grow tax free. The effect of RMDs are stunning. At the 5% per year we've been using and continuing with our 44% income tax rate and 35% investment earning tax rate, after 20 years the after-tax value of the IRA, plus the value of the cash that left the IRA as RMDs and grew with the headwind of the investment earnings tax rate, will be $1,321,490. This is $497,638 less after tax value than the Roth would have after 20 years, and represents a 136% total return versus the converted Roth's 225%.
But, aren't tax rates going up?
Why yes, you could literally have a $1 million face-value IRA today (really worth about $560,000 in 2012), grow your IRA at 5% a year for the next 15 years (thereby more than doubling its face-value to $2,078,928), but, if top combined tax rates jump to the rate of 73%, the after-tax value of your IRA will actually drop back to $561,310, thereby confiscating 15 years of gains. Think about it: the government raising income-tax rates is tantamount to enacting a massive wealth tax on IRA assets!
Beginning in 2013, the federal top marginal rate is scheduled to rise from 35% to 39.6%, the Obamacare 3.8% Medicare surcharge is kicking in, and top California income tax rates will be 13.3%. Overall, effective rates are set to jump from about 44% to around 51%. On top of this, the investment earnings tax rate is surely going up as well. The ObamaCare 3.8% kicks in on everything, income tax rate increases will drive up short-term capital gains rates and interest income rates; long-term capital gains rates are set to jump to 20%, dividends are set to revert to income tax rates, and don't forget that California has never given capital gains a favorable tax rate. Overall, it's fair to say investment earnings tax rates will jump from roughly 35% to 45%. All of this makes doing a Roth conversion in 2012, before tax rates go up for 2013, that much more compelling.
For our 50 year old, the $440,000 cash used to pay the 2012 Roth taxes will now only grow at a rate of 2.75% per year (after 45% investment earning taxes on the pre-tax 5%). Compared to the examples above (which lazily assume all 2012 tax rates will persist), this modestly increases the 20 year after-tax value of the Roth from $1,819,129 to $1,896,309, but markedly decreases the 20-year after-tax value of the IRA from 1,485,846 to $1,300,115. These tax rate changes increase the total value of the conversion after 20 years (compared to our previous example) from $333,282 to $596,193.
For our 70 year old, with higher taxes coming, the RMDs are even more damaging. The 70-year-old's after-tax IRA value plus the value of the invested RMDs will now only be worth $1,120,517 versus the after-tax Roth value of $1,896,309. For 70 year olds that make 5% per year pre-tax, given our assumed tax rates, Roth conversions will result in $775,791 more after-tax money in 20 years, compared to $497,638 with tax rates unchanged.
Just for fun, let's look at the value of a 2012 conversion after 40 years for a 50-year-old. For the Roth, the $1,000,000 will grow at 5% per year to $7,039,988, the $440,000 paid in taxes to make the conversion would have grown (with the massive tax headwind) to $1,302,344, yielding an after-tax value of $5,737,644. The IRA will grow for 20 years, then get bludgeoned by RMDs; in total, the after-tax value of the money remaining in the IRA, plus what left as RMDs and grew with the headwind of taxes will only be $2,973,067, nearly 50% less than if you had done a conversion in 2012!
Clearly, with tax rates heading higher in 2013, 2012 is your last best chance to complete a Roth IRA conversion.
The following table summarizes the value of a 2012 conversion to a 50 year old with a $1,000,000 IRA over time at different rates of return, including the impact of 2013 tax changes.
What are the risks?
Looking at the conversion conceptually, the higher your income tax and investment earnings tax rates go after you make the conversion, the more valuable the conversion becomes. However, if overall tax rates (or your personal tax rates) go way down after the conversion, the conversion will turn out to have been a bad idea. A unique offshoot of this risk is if you plan to leave your IRA and the rest of your estate to a charity. Should you pass away quickly after paying conversion taxes, those taxes will be money that goes to Uncle Sam, rather than the charity of your choice.
Another risk is that the higher your pre-tax investment return per year, the more valuable the conversion becomes, but that works both ways. Keep in mind, if the long-term investment return in your IRA turns out to be negative, then all else equal on the tax side, the value of the conversion will be negative. Another risk is that you use a large share of your non-IRA liquid net worth to pay the conversion taxes, but then have liquidity needs either within 5 years or before you hit 59.5 years old, whichever comes sooner. Removing money from a Roth before either of these deadlines will result in penalties.
The biggest risk is that you pay taxes now on your Roth conversion, grow your Roth for many years, then our friends in government re-write the laws to allow Roth distributions to be taxed, literally taxing your retirement account twice. Could happen, but I certainly think the bigger risk is the one mentioned earlier, that simply raising income tax rates (as we know will occur in 2013) is effectively a wealth tax on your IRA. I advise getting the money out of your IRA and into a Roth before taxes go up in 2013, and possibly higher down the road. At any rate, consult your tax advisor before making a conversion.
Anything else to know?
Absolutely, one of the most favorable rules regarding Roth conversions is the re-characterization rule, otherwise known as a "do over." Say you make a conversion in 2012, but then for whatever reason your account's value drops considerably before October 2013. You actually have the free option of undoing the conversion in what's termed a re-characterization. The money in your Roth goes back to the IRA, and you no longer add the converted amount to your 2012 taxable income. You have until you file your 2012 tax return, and an extension to Oct 2013 is allowed. Even if you have never filed an extension in your life, this would be the time!
Another thing: if paying income taxes on your conversion is still too much to swallow, then consider this. Provided your general 2012 income is high enough relative to your conversion amount, by making a large one-time donation to a non-profit (possibly in lieu of many smaller donations over the coming years) you can lower your 2012 taxable income by all or part of the amount of the Roth conversion. With this strategy the non-profit of your choice gets the tax money, not the government. This approach is ideal for generous folks with small IRAs relative to their overall net worth. And don't forget, the large donation could be to a donor-advised fund that will give you the full deduction this year, but let you decide later on which charity will get the money.
To conclude, let's get to the real point of Roth conversions. Money in either your IRA or your Roth IRA is the last money you'd ever touch in retirement. It makes no sense to spend assets from a tax advantaged account if you still have a dime to use in a non-tax advantaged account. You always let the retirement accounts grow tax free for as long as possible. Therefore, if you live retirement conservatively, you will very likely have an estate to leave, and an estate is tremendously more valuable to your family if it contains IRA or Roth accounts because they retain their tax advantaged status when inherited. The trouble with regular IRAs is that come age 70.5 the "IRA-decimating-RMD-siphoning-hose" arrives. Converting to a Roth allows you to live a long life, to compound your retirement assets the whole time as tax efficiently as possible, and then, when your day comes, to leave the most powerful type of tax-advantaged account the world has ever known to your children, or a non-profit, if your kids are knuckleheads.
If you have any questions, feel free to email the author, David S. Bradley, CFA, CAIA firstname.lastname@example.org.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.