Roth individual retirement accounts offer an enticing benefit: tax-free investment income in retirement.
Once someone has had the account for at least five years and reaches 59 1/2, all withdrawals are untaxed. This advantage can be costly, as converting a traditional IRA to a Roth triggers income tax that could have been deferred for years or even decades.
For high-income clients, the total tax bill (federal, state, local, Medicare surtax and other tax code wrinkles) could be about 50% of the conversion amount.
Nevertheless, Tim Steffen, director of financial planning for Robert W. Baird’s private wealth management group in Milwaukee, points to three scenarios where high-income taxpayers would consider a Roth conversion.
“One would be where converting to a Roth puts money into an account that won’t need to be touched for the rest of their life or that of their spouse,” he says.
Under current law, Roth IRA owners never have to take required minimum distributions.
“We find that some clients are reluctant to convert to a Roth IRA because they don’t see it as an asset that they can pass on to their heirs,” says Christopher D. Bilton, senior vice president and wealth management advisor with the Paxinos Lamberti Bilton & Associates team at Merrill Lynch in Chicago. “We’ve also found that with a little education, clients can and will embrace Roth IRAs as powerful multi-generational wealth accumulation tools.”
After the IRA owner and perhaps a spouse enjoy lifelong tax-free buildup, with no RMDs, the client’s children may inherit the Roth IRA and stretch tax-free distributions over their lifetimes.
Bilton reports working on Roth IRA conversions with some ultra-high-net-worth clients who have an indefinite time horizon for drawing down pre-tax retirement account balances.
“They’ve only accessed these funds and paid ordinary income taxes on the distributions when required to do so,” he says. “Their goal was to pass these assets to their children, so conversion made a lot of sense.”
HEDGING TAX HIKES
Steffen’s other two possibilities for Roth IRA conversions by high-income taxpayers involve future tax rates.
“The first would be where they expect their income to be even higher later in life, when they plan to withdraw from the IRA,” he says. “Even if they’re in a high bracket, paying the tax now may be better than paying at an even higher tax rate in the future.”
In his third scenario, high-income taxpayers may consider a Roth IRA conversion if they are very pessimistic about the future of the tax code.
“They may think that regardless of how high tax rates are today, they’re going to go up even more,” Steffen says. “Paying 35% or 39.6% tax today may not be as bad as what’s coming.”
As Bilton notes, with federal and state budget deficits, it might be safe to assume that tax rates will stay the same or be higher down the road.
Donald Jay Korn is a New York-based financial writer who contributes to On Wall Street and Financial Planning.
This story is part of a 30-day series on retirement planning strategies.