This excerpt from the Guide analyzes the factors involved in deciding whether
(and when) to convert a regular IRA to a Roth IRA.
(and when) to convert a regular IRA to a Roth IRA.
--------------------------------------------------------------------------------------------------
You may be able to realize substantial long-term tax savings by transferring funds from a
[regular] IRA to a Roth IRA. For example, you may save taxes if you are in a lower tax
bracket when you make the transfer to the Roth IRA than when you later withdraw the
funds. You may also save money by transferring high-income assets to the Roth IRA.
Finally, you may save money if you want to pass your IRA funds on to your beneficiaries
because you do not need to use them during your retirement.
Long-term Tax Savings Due to Tax Rate Differential. – You should seriously consider
transferring funds from an IRA to a Roth IRA in any year you suffer a tax loss or fall into a
low tax bracket. Although all or part of the amount transferred is taxable income, you may
be able to offset the income against your tax losses. Alternatively, you may pay tax on the
funds transferred at tax rates lower than the rates applicable to future distributions from
your IRA. In either case, you may achieve substantial long-term tax savings due to the tax
rate differential in combination with the tax-free accumulation and distribution of earnings
of the Roth IRA.
Example 1. Assume that, on July 1, 2005, your IRA distributes your entire account
balance, consisting of assets valued at $40,000. Assume you roll over $34,000 of the
distribution to a Roth IRA, and you retain the remaining $6,000 to pay the tax on the
transfer (in the 15 percent rate bracket). Assume the assets of the Roth IRA appreciate
75 percent over the next eight years. Assume further that the Roth IRA makes a
nontaxable distribution to you on July 1, 2013, when your effective tax rate is 25 percent.
Then, the funds available for your personal consumption in 2013 will be $7,000 greater
than they would have been without the transfer to the Roth IRA – illustrated as follows:
IRA Roth IRA
Account balance – 7/1/05 40,000 34,000
Fund growth over 8 years (75%) 30,000 25,500
Account balance distributed on 7/1/13 70,000 59,500
Less income tax at a 25% rate 17,500 - 0 -
After-tax funds available at 7/1/13 52,500 59,500
(A word of caution: If the taxpayer is under age 59 ½, the $6,000 retained to pay taxes may
be subject to the 10 percent penalty tax on early distributions.)
Long-term Tax Savings Due to Transfer of High Income Assets. – In any year your
regular IRAs hold assets with high income-earning potential, you should consider
transferring those assets from your IRAs to Roth IRAs. You may borrow money to pay the
tax on the amount transferred. If the rate of earnings on the high-income assets is higher
than the interest rate you must pay on your borrowing, you will generally realize long-term
tax savings. The greater the differential between the earnings rate and interest rate and the
longer the funds accumulate, the greater the potential tax savings.
You may further enhance your tax savings by borrowing under a home equity line of credit
that qualifies for interest deductions. Alternatively, you may be able to avoid borrowing
altogether by using otherwise low-yielding liquid funds to pay the tax on the transfer.
Example 2. Assume the account balance of your IRA consists of $50,000 of assets
with high-income potential. Assume that, on July 1, 2005, the trustee of your IRA
transfers the entire account balance to the trustee of a Roth IRA. Assume you borrow
$12,500 to pay the tax on the transfer (at a 25 percent tax rate). The loan is simple
interest only, at 5 percent, for eight years, with the principal and interest payable July 1,
2013.
Assume the transferred assets appreciate $100,000 over the next eight years. Assume
further that the Roth IRA makes a nontaxable distribution of the entire $150,000
account balance on July 1, 2013, when your applicable tax rate is 25 percent.
Then, the funds available for your personal consumption in 2013 will be $20,000
greater than they would have been without the transfer to the Roth IRA – illustrated as
follows:
Roth
IRA IRA
Account balance – 7/1/05 50,000 50,000
Fund growth over 8 years 100,000 100,000
Account balance distributed on 7/1/13 150,000 150,000
Less income tax (at 25% rate) or loan repayment 37,500 17,500 *
After-tax funds available at 7/1/13 112,500 132,500
* Note:
Income tax at 25% on 7/1/05 Roth conversion 12,500
Annual interest at 5% on loan to pay tax 625
Interest for 8 years 5,000
Loan principal repayment at 7/1/13 12,500
Total interest and principal 17,500
Of course, the result could be drastically different if you did not actually realize the high-
income earning potential of the assets. In that case, the sum of the tax and interest paid
after the transfer to the Roth IRA might be higher than it would have been without the
transfer.
Transfers to Roth IRAs When IRA Funds Not Needed in Retirement. – You may not
need to use your IRA funds during retirement, preferring instead to pass them on to your
beneficiaries. If so, you may find it advantageous to transfer the funds to a Roth IRA. The
advantage is that the Roth IRA is not required to make distributions during your lifetime,
whereas your IRA is generally required to make minimum distributions to you when you
reach age 70 ½ (as more fully explained in Chapter 9).
Thus, by transferring IRA funds to a Roth IRA, you avoid the tax you would otherwise pay on
required minimum distributions of those funds. Of course, offset against that advantage is
the tax you must pay on the funds at the time of their transfer to the Roth IRA. Nevertheless,
in the right circumstances, the transfer may be beneficial – even if you are in a high tax
bracket. Whether the transfer is in fact beneficial depends on a number of factors, e.g., the
life expectancies of you (or you and your spouse), the expected rate of return on the funds,
and the relative tax brackets of you and your beneficiaries.
For example, assume you transfer $60,000 from your IRA to a Roth IRA on December 31
of the calendar year you reach age 69.5 and your spouse reaches age 64.5. Assume you
in fact live exactly the period of your life expectancy, and upon your death, your spouse
elects to own your Roth IRA. Assume that your spouse lives out exactly the period of the
joint and survivor life expectancy of you and your spouse.
Assume further that you and your spouse are in a 25 percent bracket and your ultimate
beneficiaries are your children who will be in 15 percent brackets. Then, with an annual
rate of return of 6 percent, your children would receive approximately $32,000 more (after
tax) than they would have received if you had not transferred the funds to a Roth IRA. On
the other hand, if you and your spouse do not live out your life expectancies, the tax
savings will be less – and may even be negative.
Table XII in the Appendices illustrates this computation using the facts assumed in the
previous two paragraphs. If you are considering a Roth IRA transfer to avoid tax on
required minimum distributions, you and your tax advisor should make a similar
computation taking into account your own circumstances and assumptions.
--------------------------------------------------------------------------------------------------
You may be able to realize substantial long-term tax savings by transferring funds from a
[regular] IRA to a Roth IRA. For example, you may save taxes if you are in a lower tax
bracket when you make the transfer to the Roth IRA than when you later withdraw the
funds. You may also save money by transferring high-income assets to the Roth IRA.
Finally, you may save money if you want to pass your IRA funds on to your beneficiaries
because you do not need to use them during your retirement.
Long-term Tax Savings Due to Tax Rate Differential. – You should seriously consider
transferring funds from an IRA to a Roth IRA in any year you suffer a tax loss or fall into a
low tax bracket. Although all or part of the amount transferred is taxable income, you may
be able to offset the income against your tax losses. Alternatively, you may pay tax on the
funds transferred at tax rates lower than the rates applicable to future distributions from
your IRA. In either case, you may achieve substantial long-term tax savings due to the tax
rate differential in combination with the tax-free accumulation and distribution of earnings
of the Roth IRA.
Example 1. Assume that, on July 1, 2005, your IRA distributes your entire account
balance, consisting of assets valued at $40,000. Assume you roll over $34,000 of the
distribution to a Roth IRA, and you retain the remaining $6,000 to pay the tax on the
transfer (in the 15 percent rate bracket). Assume the assets of the Roth IRA appreciate
75 percent over the next eight years. Assume further that the Roth IRA makes a
nontaxable distribution to you on July 1, 2013, when your effective tax rate is 25 percent.
Then, the funds available for your personal consumption in 2013 will be $7,000 greater
than they would have been without the transfer to the Roth IRA – illustrated as follows:
IRA Roth IRA
Account balance – 7/1/05 40,000 34,000
Fund growth over 8 years (75%) 30,000 25,500
Account balance distributed on 7/1/13 70,000 59,500
Less income tax at a 25% rate 17,500 - 0 -
After-tax funds available at 7/1/13 52,500 59,500
(A word of caution: If the taxpayer is under age 59 ½, the $6,000 retained to pay taxes may
be subject to the 10 percent penalty tax on early distributions.)
Long-term Tax Savings Due to Transfer of High Income Assets. – In any year your
regular IRAs hold assets with high income-earning potential, you should consider
transferring those assets from your IRAs to Roth IRAs. You may borrow money to pay the
tax on the amount transferred. If the rate of earnings on the high-income assets is higher
than the interest rate you must pay on your borrowing, you will generally realize long-term
tax savings. The greater the differential between the earnings rate and interest rate and the
longer the funds accumulate, the greater the potential tax savings.
You may further enhance your tax savings by borrowing under a home equity line of credit
that qualifies for interest deductions. Alternatively, you may be able to avoid borrowing
altogether by using otherwise low-yielding liquid funds to pay the tax on the transfer.
Example 2. Assume the account balance of your IRA consists of $50,000 of assets
with high-income potential. Assume that, on July 1, 2005, the trustee of your IRA
transfers the entire account balance to the trustee of a Roth IRA. Assume you borrow
$12,500 to pay the tax on the transfer (at a 25 percent tax rate). The loan is simple
interest only, at 5 percent, for eight years, with the principal and interest payable July 1,
2013.
Assume the transferred assets appreciate $100,000 over the next eight years. Assume
further that the Roth IRA makes a nontaxable distribution of the entire $150,000
account balance on July 1, 2013, when your applicable tax rate is 25 percent.
Then, the funds available for your personal consumption in 2013 will be $20,000
greater than they would have been without the transfer to the Roth IRA – illustrated as
follows:
Roth
IRA IRA
Account balance – 7/1/05 50,000 50,000
Fund growth over 8 years 100,000 100,000
Account balance distributed on 7/1/13 150,000 150,000
Less income tax (at 25% rate) or loan repayment 37,500 17,500 *
After-tax funds available at 7/1/13 112,500 132,500
* Note:
Income tax at 25% on 7/1/05 Roth conversion 12,500
Annual interest at 5% on loan to pay tax 625
Interest for 8 years 5,000
Loan principal repayment at 7/1/13 12,500
Total interest and principal 17,500
Of course, the result could be drastically different if you did not actually realize the high-
income earning potential of the assets. In that case, the sum of the tax and interest paid
after the transfer to the Roth IRA might be higher than it would have been without the
transfer.
Transfers to Roth IRAs When IRA Funds Not Needed in Retirement. – You may not
need to use your IRA funds during retirement, preferring instead to pass them on to your
beneficiaries. If so, you may find it advantageous to transfer the funds to a Roth IRA. The
advantage is that the Roth IRA is not required to make distributions during your lifetime,
whereas your IRA is generally required to make minimum distributions to you when you
reach age 70 ½ (as more fully explained in Chapter 9).
Thus, by transferring IRA funds to a Roth IRA, you avoid the tax you would otherwise pay on
required minimum distributions of those funds. Of course, offset against that advantage is
the tax you must pay on the funds at the time of their transfer to the Roth IRA. Nevertheless,
in the right circumstances, the transfer may be beneficial – even if you are in a high tax
bracket. Whether the transfer is in fact beneficial depends on a number of factors, e.g., the
life expectancies of you (or you and your spouse), the expected rate of return on the funds,
and the relative tax brackets of you and your beneficiaries.
For example, assume you transfer $60,000 from your IRA to a Roth IRA on December 31
of the calendar year you reach age 69.5 and your spouse reaches age 64.5. Assume you
in fact live exactly the period of your life expectancy, and upon your death, your spouse
elects to own your Roth IRA. Assume that your spouse lives out exactly the period of the
joint and survivor life expectancy of you and your spouse.
Assume further that you and your spouse are in a 25 percent bracket and your ultimate
beneficiaries are your children who will be in 15 percent brackets. Then, with an annual
rate of return of 6 percent, your children would receive approximately $32,000 more (after
tax) than they would have received if you had not transferred the funds to a Roth IRA. On
the other hand, if you and your spouse do not live out your life expectancies, the tax
savings will be less – and may even be negative.
Table XII in the Appendices illustrates this computation using the facts assumed in the
previous two paragraphs. If you are considering a Roth IRA transfer to avoid tax on
required minimum distributions, you and your tax advisor should make a similar
computation taking into account your own circumstances and assumptions.
--------------------------------------------------------------------------------------------------
The Glossary of the Guide provides the following definition for a Roth IRA:
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Roth IRA – An IRA ... with some significantly different attributes that distinguish it from a
regular IRA. The primary differences are that (1) an individual may not make deductible
contributions to a Roth IRA, (2) transfers from IRAs to Roth IRAs are generally taxable, and
(3) “qualified distributions” from Roth IRAs are generally not taxable. In most other respects,
the rules that govern Roth IRAs are the same as those that govern regular IRAs.
---------------------------------------------------------------------------------------------------
Roth IRA – An IRA ... with some significantly different attributes that distinguish it from a
regular IRA. The primary differences are that (1) an individual may not make deductible
contributions to a Roth IRA, (2) transfers from IRAs to Roth IRAs are generally taxable, and
(3) “qualified distributions” from Roth IRAs are generally not taxable. In most other respects,
the rules that govern Roth IRAs are the same as those that govern regular IRAs.
---------------------------------------------------------------------------------------------------
| Copyright © 2005-2008 by Vorris J. Blankenship All Rights Reserved |
The author intends that this website provide accurate and authoritative information on the subject matter
covered. However, the information provided on this website is not a substitute for the advice of an attorney,
accountant, or other professional; and the author is not offering legal, accounting, or other professional
advice. The material presented on this website is not intended for use, and may not be used, to avoid tax
penalties. If you need legal advice or other professional help, you should seek (from an independent attorney,
accountant, or other competent professional) advice based on your own particular circumstances.
covered. However, the information provided on this website is not a substitute for the advice of an attorney,
accountant, or other professional; and the author is not offering legal, accounting, or other professional
advice. The material presented on this website is not intended for use, and may not be used, to avoid tax
penalties. If you need legal advice or other professional help, you should seek (from an independent attorney,
accountant, or other competent professional) advice based on your own particular circumstances.
Excerpt from the Guide - Converting IRAs to Roth IRAs
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