IRA choices to convert or not to convert? Roth IRA conversions in 2010: issues and opportunities.
Investors should be aware of tax and other implications from accumulating assets in. (and transferring assets from) commonly used investment accounts. The ability to contribute amounts on a before-tax basis to generate tax-deferred yields in traditional IRAs--or on an after-tax basis to generate tax-free yields in Roth IRAs--provides an effective vehicle to accumulate retirement assets. Investors should keep in mind the optimal asset allocation within investment accounts in light of the dramatically different tax treatments provided to traditional and Roth IRAs, as well as to currently taxable accounts. For example, while both types of IRAs are effective tools to build wealth through tax-deferred or tax-free growth, some investors may be better off making certain investments in taxable accounts. The accumulation of assets in taxable accounts provides not only the flexibility that liquid assets afford (without concern for penalties that might apply in the case of early withdrawals) but may also provide an opportunity to pay less taxes in certain circumstances than an IRA.
Types of Investment Accounts
Contributions to taxable accounts and Roth IRA accounts are made with aftertax funds. In other words, no income tax deduction is permitted for such contributions. Contributions to a traditional IRA are deductible in determining adjusted gross income (AGI) if the taxpayer qualifies (e.g., under certain AGI levels if covered by an employer-sponsored retirement plan). According to IRS data, approximately 3.2 million taxpayers deducted $12.5 billion for IRAs on their 2006 tax returns. (See Publication 1304, Table 1.4, www.irs.gov/taxstats/indtaxstats/article/0,,id=96981, 00.html.) Taxpayers who are ineligible are still allowed to make contributions to a traditional IRA; however, no deduction is permitted.
In the case of taxpayers who contribute to a nondeductible traditional IRA, withdrawals are taxed on a pro-rata portion of the distribution, as the tax law taxes the gain portion and exempts the initial contributions under the return-of-capital doctrine. While there are many taxpayers who make nondeductible contributions to traditional IRAs--typically, in an effort to enjoy tax-deferred compounding of earnings--for the sake of brevity, this article will not address these accounts, although it is possible such taxpayers may also consider converting to a Roth IRA. Any reference to traditional IRAs refers to IRAs for which a full deduction was permitted.
Investments in taxable accounts are generally subject to current taxation as income is received and gains are realized. Some of these items (e.g., interest other than from municipal bonds, net short-term capital gains) are taxed at the ordinary marginal tax rate--currently as high as 35%--while other items (e.g., qualified dividends, net long-term capital gains) are taxed at favorable rates (currently no more than 15%). An overall net capital loss reduces AGI up to $3,000 per year and saves taxes at the ordinary marginal tax rate, with any excess loss carried over to benefit future years' tax returns.
Investments held inside a traditional IRA are taxed only when funds are distributed to the accountholder. Distributions are taxed at the marginal rate for ordinary income, even if their underlying character would have been a qualified dividend or long-term capital gain (normally taxed at a lower rate), or tax-exempt interest. On the other hand, distributions from a Roth IRA are tax-free when distributed to the accountholder. A 10% penalty for early withdrawals (typically, before age 59 1/2) may also apply in certain cases for both traditional and Roth IRAs, and certain withdrawals from Roth IRAs within five years of setting up the account may also be subject to similar penalties. Certain exceptions (typically for enumerated hardships) apply to both types of accounts. Distributions from traditional IRAs must also begin by April 1 of the year after the accountholder turns 70 1/2 to avoid penalties.
Before 2010, taxpayers with modified AGI under $100,000 were permitted to convert amounts held in a traditional IRA to a Roth IRA. (Modified AGI is determined by adjusting AGI for certain deductions [e.g., traditional IRA contributions, student loan interest] and exclusions [e.g., employer-provided adoption benefits]. Special rules apply for married taxpayers who file separately.) Taxpayers with modified AGI over $100,000 are allowed to convert starting in 2010, when the AGI limits are removed. Conversion to a Roth IRA increases AGI by the amount converted in that year, and thus the investor needs cash to pay taxes based on the amount converted. (If the conversion is large enough, it may push taxpayers into higher tax brackets, thus subjecting portions of the conversion to higher rates.) If the conversion is made in 2010, however, there is a one-time option to pay the taxes owed on the conversion over two years instead of one. Individuals who convert amounts by directly rolling over from a traditional IRA to a Roth IRA will not be assessed the 10% early withdrawal penalty.
Factoring Taxes into Life Planning
When assessing their net worth or determining whether a plan will provide enough assets to retire comfortably, investors should discount assets held in traditional IRAs to properly include them at their after-tax value, based upon their expected future income tax rate at the time funds are distributed. (The authors refer to this as an investor's own "mental accounting." It is not uncommon for external assessors of investors' financial position to make similar adjustments. For example, some mortgage companies reduce tax-deferred retirement plans by an amount to reflect taxes when assessing potential borrowers' financial position.) To the extent that taxable accounts have unrealized gains, a discount should similarly he applied; however, the haircut will probably be smaller because as-yet-unrecognized long-term capital gains will be taxed at favorable rates. On the other hand, the value of a Roth IRA does not need to be discounted to account for future income taxes.
Taxpayers who plan to prematurely withdraw funds from IRAs without the benefit of a hardship exception should value their account net of income taxes and also net of the 10% early withdrawal penalty. Of course, taxpayers are not always able to forecast their cash flow needs, so some taxpayers under 59 1/2 find that they have mistakenly locked up too much value in their IRAs. This may expose them to potential penalties if an unexpected life event forces an early distribution.
Financial advisors have traditionally recommended that clients maintain at least six months of living expenses in highly liquid, near-cash investments in case of job loss; however, other unforeseen life events can also require additional funds. Examples that are especially relevant during the recent economic crisis include a transition to a lower paying job, a midlife career change that includes the need for substantial retraining, an unplanned early retirement before age 59 1/2, or perhaps potential foreclosure on a home. Examples of more positive events include starting up a new business venture; the purchase of a second home; or helping children with the costs of their wedding, college, or the purchase of their first home. To provide the flexibility to respond to a range of life events, investors who are otherwise not able to avoid early withdrawal penalties should plan on maintaining some amounts in a taxable account.
While investors should keep some of their investments in taxable accounts so that they can be made available quickly, they should also keep certain investments in traditional or Roth IRAs to take advantage of their tax features. Changes in the tax law that take effect in 2010 are prompting many taxpayers to ask whether they should convert some or all of the balance in a traditional IRA to a Roth ERA. The advantage of future tax-free withdrawals from a Roth IRA has to be weighed against the disadvantage of triggering a currently taxable event.
The Conversion Question
Whether converting a traditional IRA into a Roth IRA makes financial sense for an investor depends on many factors, including whether the investor will face a higher or lower tax rate in retirement. While current ordinary marginal rates are likely 25% or 28%, depending on marital status, for taxpayers with AGI slightly over $100,000, the marginal rates rise rather quickly to 33%, and usually hit the current maximum of 35% as AGI approaches $400,000.
It is difficult to predict what tax rates will apply to future distributions from traditional IRAs for two reasons. First, taxpayers often cannot forecast their own future marginal tax rate due to the uncertainty of taxable income flows; second, tax rates often change. Current expectations are that expanded deficit spending will place pressure on Congress to increase marginal income tax rates for the foreseeable future. Even if Congress does nothing, the tax cuts enacted during the Bush presidency are set to expire in 2011, with ordinary marginal tax rates to increase from 35% to 36% and 39.6%. In addition, long-term capital gains will return to the 20% tax rate, and qualified dividends will no longer receive favorable treatment. Current proposals in Congress could subject taxpayers with an AGI of $350,000 to a surcharge of up to 5.4%. While no one knows exactly what tax rates will be for high-income taxpayers in the near future, tax rates are not likely to be lower than in 2010.
Accordingly, taxpayers expecting to face higher income tax rates in the future should seriously consider converting at least a portion of their traditional IRAs to a Roth IRA in 2010. This clearly includes high-income taxpayers who expect to continue to be in the higher tax brackets once IRA distributions commence. Exhibit I illustrates this benefit over time. It assumes a gross value of $100 starting in 2010, which is expected to grow annually at a before-tax yield of 6%. The blue line represents the value of a traditional IRA before any discount is applied for income taxes. The green line represents the same traditional IRA's value, discounted for taxes at the highest assumed marginal rate of 35% in 2010 and 45% after 2010. The red line represents the value of the same investment if the traditional IRA is converted to a Roth IRA in 2010 and taxes are paid at the highest marginal tax rate (35% in 2010). To simplify the illustration, funds are assumed to be deducted immediately from the traditional IRA account to pay the taxes due at conversion. Note that financial advisors recommend that investors pay conversion-related taxes from a source other than the traditional IRA
As seen in Exhibit I, the before-tax value of assets held in a traditional IRA account is significantly higher than when the same amount is converted to a Roth IRA. In 2010, the $100 investment held in a traditional IRA is worth $65 in a Roth IRA. But the Roth IRA's after-tax value in future years can be expected to be higher than the traditional IRA when the latter is reduced to its expected after-tax value, as tax rates will increase after 2010. Withdrawals from traditional IRAs after 2010 are assumed to be taxed at rates higher than the current 35% rate. In other words, by converting in 2010, before tax rates increase, future earnings will escape the tax increase.
Even if tax rates merely reach the scheduled rate of 39.6%, as opposed to the 45% rate used for illustration purposes, the savings from conversion to a Roth IRA are still material for many taxpayers. Furthermore, besides the tax savings, Roth IRAs have no minimum required distributions, which increases flexibility in the timing of withdrawals. Other than the chance that tax rates for a given taxpayer may be lower at distribution than at Roth conversion, the only downside is the fact that a taxpayer between 54 h. and 59 k must be concerned about the five-year lockup period.
Revisiting Ideal Asset Allocation
The difference in the after-tax value of assets held in traditional or Roth IRAs (or converted to a Roth IRA) depends greatly upon asset allocation decisions. This is because traditional IRA withdrawals are taxed at ordinary income rates, regardless of whether the underlying asset would be accorded more favorable tax treatment, such as reduced rates on long-term capital gains or qualifying dividends, or even tax-free interest on municipal bonds. Even with the scheduled increase in dividend and long-term capital gains rates to 20%, the taxes paid on traditional IRA distributions sourced from dividends and capital gains can be approximately twice what it would be if those assets were held in a taxable account; it would take many years for that excessive cost to be offset by the time-value benefit of deferring the payment of such taxes in a traditional IRA. As discussed earlier, there would be no taxes if those assets were held in a Roth IRA (although there would be tax on the value of the IRA at conversion).
The target amount that each individual should invest in each asset class (e.g., equity, fixed income, real estate, commodities) is a complicated subject, and a detailed analysis is beyond the scope of this article. For example, diversification of investments among asset classes reduces total asset volatility and improves long-term portfolio returns. Whatever the optimal allocation among different asset classes, however, an investor should attempt to match the asset class to the before- or after-tax account that will most likely optimize after-tax results.
As noted above, taxable accounts are an important vehicle to provide liquidity, and a minimum of six months of living expenses should be held in cash and near-cash instruments that have stable values and no early withdrawal penalties (e.g., not long-term certificates of deposit, stocks, or long-term bonds). Investors should separately consider how to invest additional funds held in a taxable account, taking their risk preferences into account. Assets invested in stable investments provide lower cur-pent returns and better flexibility to meet unforeseen life events. Assets invested in stocks and other risky assets provide the possibility of future financial flexibility, which, when realized, provide an investor with more assets to fund lifestyle choices. As many market participants recently learned, however, losses on equity investments are a very real possibility.
When investments held in taxable accounts suffer losses, as in the recent stock market downturn, investors can generally reduce current taxes through the selective sale of investments to harvest unrealized losses. Stocks are generally subject to price volatility; therefore, stock sales can be timed to match unrealized losses with unrealized gains, and, as discussed earlier, any excess losses over gains can be used to shield current and, if over $3,000, future years' income from taxation. Allocating stocks to a Roth IRA eliminates future taxes on the price appreciation, but also eliminates the option to harvest losses to shield current taxable income. Therefore, growth (i.e., low-dividend paying) stocks generally should be allocated to taxable accounts (where they can be taxed at favorable rates) or Roth IRAs (where they escape taxation completely), instead of traditional IRAs.
While high-yield (i.e., high-dividend paying) stocks generally experience less price volatility than growth stocks, both involve substantial price risk. High-yield common stocks (and preferred stocks) that do not pay qualifying dividends (e.g., real estate investment trusts, trust preferred stocks, and many foreign stocks) should first be allocated to Roth IRA. On the other hand, common stocks that generate a stable flow of qualifying dividends (e.g., utilities) and preferred stocks paying qualified dividends should be kept in Roth IRAs or taxable accounts. Investments in municipal bonds should be held only in taxable accounts to compensate for their lower after-tax yield. Fixed-income securities--including certificates of deposit, bond funds and individual bonds (except municipal bonds), as well as other assets that are expected to have only modest price appreciation--are best kept in a traditional IRA if the investor decides not to convert everything to a Roth IRA.
Roth IRAs are ideal for holding assets with significant price appreciation potential, including growth stocks and certain exchange-traded funds (ETF) that would be taxed at the 28% collectibles tax rate if held in a taxable account. ETFs that hold commodities as their underlying assets, such as gold and silver ETFs, are an effective way to hold commodities. If these assets are held in a taxable account, long-term capital gains are taxed at the 28% collectibles rate; therefore, any investment in commodity-linked ETFs should be held in a Roth IRA. ETFs that are not commodity-linked are generally more tax efficient than actively managed mutual funds in that the investor has more control over when to recognize capital gains or losses through the sale of the ETF, and such ETFs are not taxed at the 28% rate applicable to commodity ETFs. Noncommodity ETFs that distribute dividends or interest can still trigger currently taxable income. Therefore, noncommodity ETFs are well suited for a Roth IRA or taxable account.
Evaluating the Options
In summary, if an investor takes advantage of the Roth IRA conversion rules in 2010, it is also an optimal time to rebalance the portfolio. An investor should first identify the optimal asset allocation for the portfolio as a whole and then identify which account type (traditional IRA, Roth IRA, or taxable account) is best suited to hold the investments in each asset class to maximize the portfolio's after-tax value. Subject to personal risk preferences and prevailing market conditions, Exhibit 2 can be used as a general rule of thumb to prioritize matching the investment asset class to the preferred account type. Note that Exhibit 2 excludes short-term emergency funds that should cover at least six months of expenses. Those funds should always be kept in stable-value assets such as money market funds, cash, or short-term certificates of deposit. In addition, because cash can be held in all three accounts, it is omitted from the chart.
EXHIBIT 2 Summary of Account Preferences Investment Taxable Traditional Roth Account IRA IRA Certificates of deposit x x Municipal bonds x Common stocks (no- or low-dividend) x x Common stocks (nongrowth), preferred x x stocks (paying qualified dividends) Common stocks (paying nonqualified x dividends) Exchange-traded funds (not x x commodity-linked) ETFs (commodity-linked) x Preferred stocks (not paying qualified x x dividends), bonds (other than municipal bonds)
In Exhibit 2, the suggested preference of where to hold each investment--taxable account, traditional IRA, Roth IRA--is indicated by an X in corresponding column. If investors hold more than a basic amount of emergency funds in taxable accounts, some asset categories are also well suited for taxable accounts. For example, as discussed above, it would be preferable to hold growth stocks in a Roth IRA. If an investor has the appropriate risk profile, a portion of nonemergency funds held in a taxable account might also be invested in growth stock, whereas a traditional IRA would be the least preferable place to hold this type of asset.
To the extent an investor has decided not to convert traditional IRA balances to a Roth IRA, the traditional IRA is the best vehicle to hold assets that are expected to have only modest price appreciation, such as fixed-income securities. Such an investor might also decide that the disadvantages of holding stocks in a traditional IRA are outweighed by its other advantages.
Robin Knowles, CFA, is a PhD candidate at the University of Connecticut school of business, Stows, Conn. Stanley Veliotis, PhD, CPA, LLM, is an assistant professor of taxation at the Fordham University schools of business, Bronx, N. Y. The authors would like to thank Paul Kushel and Mike Redemske for comments on an earlier version of this article.
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|Title Annotation:||In Focus|
|Author:||Knowles, Robin; Veliotis, Stanley|
|Publication:||The CPA Journal|
|Date:||Jan 1, 2010|
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