A Roth Conversion is done when assets are distributed from an IRA and put into a Roth IRA. This distribution from the IRA is taxable. The taxpayer should have the cash from another source (not the IRA funds) to pay the tax. The benefit to a Roth IRA is that if the account is open for at least 5 years and distributions don’t begin until age 59 ½ then all of the distributions are tax-free. For people that have enough other resources, they may not ‘need’ the assets in their IRA.
Currently the highest federal ordinary income tax rate is 35%. This is schedule to go to 39.6% beginning in 2013. This is just the expiration of the so-called ‘Bush Era Tax Cuts’ from when President George Bush cut income tax rates. Given the staggering deficits the Federal Government is running, it’s easy to see even more tax increases down the road.
By doing a Roth Conversion, you are accelerating the income and the income taxes. The payment of these taxes will reduce your net-worth and therefore estate taxes. The federal estate tax exclusion is $5.2 million dollars for 2012. If Congress doesn’t act, this will be reduced to $1 million dollars beginning in 2013. Additionally the tax rate will increase from 35% to 55%.
With an IRA investors must begin to their RMD from the account when they turn 70 ½. There is no requirement for a taxpayer or their surviving spouse to take RMD’s from a Roth IRA. Non spousal beneficiaries like children or grandchildren will have to take RMD if they inherit a Roth IRA. But if the Roth meets the basic requirements above, the distributions will be tax-free anyway. By not having any RMD requirements during the taxpayers or surviving spouse’s lifetime, the Roth IRA is allowed to grow tax-free for either the children or grandchildren. The tax-free compounding of this over time can be huge. The Roth Conversion becomes a wonderful wealth transfer tool.
ACTION ITEM: Affluent people should take a hard look at a Roth Conversion. For some people it may be an appropriate strategy.
Thomas F. Scanlon, CPA, CFP®
The information in this report does not purport to be a complete description of the securities, markets or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Thomas F. Scanlon, CPA, CFP® and not necessarily those of RJFS or Raymond James. Tax laws are subject to future revisions. Raymond James does not offer tax advice. Please consult a tax advisor for any tax related issues.