12/12/05 - Roth Conversions for Retirees
By: Richard Feldman, CFP, AIF
A provision in the tax law adopted in 1998 finally kicked into effect on January 1st 2005. The new provision could be a great estate planning tool for certain affluent retirees allowing them to pass on greater after tax savings to their children and grandchildren. The provision that came into effect on January 1st of this year will allow individuals to exclude required minimum distributions made from their traditional IRAs when computing their modified adjusted gross income. This will make it easier for retirees to meet the $100,000 modified adjusted gross income limit for converting a traditional IRA to a Roth IRA.
RMDs Excluded from MAGI
"If you are 70 ½ or older and are considering converting a traditional IRA to a Roth IRA after 2004, you may disregard the amount of your required minimum distributions (RMDs) from the traditional IRA in figuring whether your MAGI exceeds the $100,000 limit for a conversion. For a pre - 2005 conversion, required minimum distributions were counted towards the $100,000 MAGI limit."[1]
Roth IRA Basics
You have access to a Roth IRA through two vehicles. The first being a contributory Roth IRA which in 2005 through 2007 the contribution limit is $4,000 and increasing to $5,000 in 2008 and beyond. The maximum annual Roth IRA contribution limit is phased out if your modified adjusted gross income is between:
- $150,000 and 160,000, if you are married filing jointly, or a qualifying widow/widower,
- $95,000 and $110,000, if you are single, head of household, or married filingseparately and you lived apart for the entire year;
- $0 and $10,000, if you are married filing separately and you lived with your spouse atany time during the year.
The other vehicle that you may access a Roth IRA is a Roth Conversion. If your modified adjusted Gross income (MAGI) is $100,000 or less, and you are not married filing separately, you may make a taxable conversion of a traditional IRA to a Roth IRA. This limit is for individuals who are single or married.
Roth Conversion Benefits
To see how a Roth IRA might benefit you take a look at the required minimum distribution schedules I have attached in the following table. These distribution schedules are based on an IRA account of $750,000 compounded at a 7% growth rate.
[1] JK Lasser,s, "Your Income Tax 2005"
Why would anyone pay tax now that they could defer into the future? The reason would be that you might be able to pay less tax now than later. The schedule above shows that the required minimum distributions would end up moving most retiree's into a higher tax bracket in the future.
A strategy might be to convert a portion of the retirement account to a Roth IRA now thus reducing the amount of required minimum distributions and thus taxable income in the future. The strategy works best if you have the funds outside of retirement accounts to pay taxes that would be due on the conversion of a traditional IRA to a Roth IRA. In addition the taxes paid would remove the funds from your estate thus avoiding estate taxes assuming your estate is large enough to be taxed when distributed to your heirs.
Converting to a Roth IRA is not irrevocable. The government gives you until October 15th of the year after you convert to switch back to a traditional IRA. If it turns out your income was greater than the $100,000 threshold in the conversion year or the value of your Roth has dropped in value, you can undo the conversion by October 15th . This would allow you to get a refund of the conversion tax you paid in the previous year and after waiting 30 days you would once again be eligible for a conversion.
Summary
If your income in retirement is already sufficient to support your lifestyle and you do not require the full balance of your retirement account to supplement your income, than a Roth IRA conversion might be a way to pass on a greater amount of after tax funds to your children and grandchildren.
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