2010 Estate Planning: Roth IRA Conversion Considerations

Q&A with Mitch Drossman, Head of National Wealth Strategies for U.S. Trust, Bank of America Private Wealth Management, and Ramzi Nuwayhid, Wealth Management Advisor for Merrill Lynch Global Wealth Management, Boston

What impact may the 2010 Roth IRA conversion rule change have on estate planning?

According to findings from Affluent Insights Quarterly, a survey report released by Merrill Lynch Global Wealth Management in October, 49 percent of affluent Bostonians consider estate planning a high priority. In light of recent economic conditions, many of our clients are asking about how to preserve their estate and provide for their heirs.

For many, part of the answer may reside in the changing tax law governing Roth IRA conversions. With the 2010 Roth IRA rule change, assets that were previously taxed under the minimum distribution requirement are now able to grow tax-free should an individual elect to convert. This benefit creates a greater opportunity for wealth to accumulate over the years and may lead to even greater net-after-tax assets available to beneficiaries and heirs.

Should an investor pay taxes on Roth IRA conversion in 2010 or take advantage of the option to spread tax liability over two years?

Although individuals who convert in 2010 have the option to spread tax liability over two years (2011 and 2012), it is important to note that this option may be more beneficial to an individual at a somewhat lower income level than for higher income taxpayers. The reason for this is that it is anticipated that the higher income taxpayer may have higher income tax rates in 2011 and 2012 (vis-à-vis 2010). Thus, we recommend individuals considering Roth conversion not approach this option in terms of deferring tax payment, but rather approach it in terms of greater net-after-tax returns.

In other words, look not only at the issue of deferring taxes, but holistically at the conversion. Instead of considering the cost of conversion as being the payment of income tax, what individuals should consider is whether the “up-front” payment of tax would yield a longer-term net-after-tax benefit. For many, especially those who may be subject to an estate tax, conversion could yield greater net-after-tax benefits, and also eliminate the uncertainty of future income tax increases.

When transferring their estate, how might Roth IRA conversion affect an investor’s heirs?

A conversion may benefit heirs by potentially increasing their inheritance and providing a tax-free source of income. Generally, one’s heirs will inherit the Roth IRA without having to pay income taxes on the distribution. The Roth IRA will continue to grow tax-free throughout an heir’s life, as well – heirs may take distributions based on their life expectancy, which are also tax-free.

When one has a Traditional IRA, he or she has to take his so-called “Required Minimum Distributions” (or RMDs) upon attaining the age of 70 ½, whereas with a Roth IRA, there is no RMD required. Thus, if the investor does not convert, he or she will have to take RMDs from his or her Traditional IRA. Additionally, those who inherit Traditional IRAs will have to take RMDs over their lifetimes and the distributions will be taxable to them. By comparison, if he or she converts, not only is there no RMD during life (so assets grow tax free), but when the beneficiary inherits the Roth IRA, although at that time the beneficiary has to take his or her RMDs (based on his or her life expectancy), the distributions from Roth IRAs are generally tax-free.

Simply put, converting to a Roth IRA may generate greater net-after-tax assets to an individual and/or his or her heirs, while also creating a tax-free vehicle that will grow the rest of one’s life and/or throughout the lives of their heirs.

From where should an investor draw assets to pay for the Roth IRA conversion tax?

The income tax on conversion should be paid from non-retirement accounts (i.e., don’t pay the income tax from IRA or Roth IRA assets). The reason for this is that if the investor opts to pay taxes from his or her Roth IRA, he or she would be taking assets from an account that can grow tax-free (i.e. the Roth IRA) and using it to pay taxes, instead of taking it from a taxable account.

For wealthier individuals and families, our analyses generally show that the greatest benefit for an individual may be to keep assets in a Roth IRA as long as permissible. Therefore, wealthier investors who anticipate needing to withdraw significant amounts from their Roth during their lifetime should carefully consider whether conversion is right for them.

To that end, a Roth IRA conversion is not going to be right for everyone. Due to the uniqueness of each individual’s profile, individuals should consult with their financial advisor or wealth strategist as well as tax and estate planning professionals to comprehensively reflect on the opportunities this tax law modification may offer to their particular retirement and estate plan.