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Introduction

Traditional and Roth IRAs are two powerful tax-advantaged savings vehicles. While Roth IRAs were first established in 1997, historically low tax rates during the past decade and the ability of investors of all income levels to convert Traditional IRAs to Roth IRAs (since 2010) have brought Roth IRAs into the limelight today. In order to determine if a conversion of a Traditional IRA to a Roth IRA is pertinent, high net worth individuals considering conversions must understand the key differences between the two retirement savings vehicles. Once the pros and cons of each retirement savings vehicle are understood, then high net worth individuals have to weigh several key factors, many of which require making assessments about uncertain future events (e.g., future tax rates, future income levels, and potential wealth transfer goals), in order to make an informed decision about conversion.

The following commentary provides a high level overview of the basic differences between how Traditional IRAs and Roth IRAs work (an exhaustive review of each type of IRA is beyond the scope of this analysis), and then discusses the key factors that must be assessed in order to determine under what circumstances converting may or may not be appropriate. This information is intended as general education and does not represent a recommendation for or against any specific high net worth individual converting their Traditional IRA to a Roth IRA. We recommend that high net worth investors discuss their specific situation with a qualified tax professional prior to making a decision.

Key Differences between Traditional IRAs and Roth IRAs

While both Traditional IRAs and Roth IRAs provide tax-advantaged growth, the tax benefits occur at different times. For example, Traditional IRAs provide tax-deferred growth and are funded with either pre-tax or after-tax dollars¹. Pre-tax contributions to Traditional IRAs are tax-deductible in the year the assets are contributed and grow on a tax-deferred basis until distributed. At the time of distribution, the investor owes income tax (Federal income tax, as well as any applicable state and local income taxes) on the entire distribution. Individuals who do not qualify for the tax-deductible contributions can make contributions with after-tax dollars (i.e., a non-deductible IRA). In this case, the contributed principal is returned income tax free, while the income is taxed. Furthermore, investors are generally required to start withdrawing from their Traditional IRAs beginning at age 70½, taking what the IRS calls “required minimum distributions,” or RMDs.

Unlike Traditional IRAs, which defer taxes until the assets are distributed, Roth IRA contributions² are always made with after-tax dollars and generally grow on a tax-free basis. In addition, distributions of contributed principal are income tax free, while earnings are distributed income tax free as long as the distribution is qualified³. Furthermore, there are no lifetime required minimum distribution constraints for Roth IRAs. Table 1 below highlights the key differences between Traditional IRAs and Roth IRAs as it relates to contributions, the taxation of withdrawals, and RMDs.

Converting a Traditional IRA to a Roth IRA

As previously mentioned, taxpayers, regardless of their Modified Adjusted Gross Income, are permitted to convert Traditional IRA assets to a Roth IRA. In general, converting Traditional IRA assets to a Roth IRA requires the high net worth individual to recognize as ordinary income the amount converted less any cost basis that the individual may have in the Traditional IRA, which is generally zero unless non-deductible (after-tax) contributions were made to the Traditional IRA. There are several factors, many of which require high net worth investors to make assumptions about uncertain future events, which need to be assessed in order to determine if a Roth IRA conversion is appropriate.

Current Tax Rates and Potential Future Tax Rates

Individuals need to determine the relationship between their expected future income tax rates when they would withdraw the assets versus the tax rates in place at the time of conversion. In general, two factors need to be considered here. First, amounts that are converted from a Traditional IRA to a Roth IRA are fully taxed as income in the year of conversion (minus accumulated non-deductible contributions). As such, conversion is likely to result in a higher effective tax rate on the conversion amount (as well as other income earned that year), potentially creating a meaningful tax bill. Therefore, individuals who anticipate that their withdrawals/income would put them in a lower tax bracket later in life may be better off by not converting their Traditional IRA to a Roth IRA. In addition to paying a higher marginal income tax rate on conversion income, a large Roth IRA conversion will increase an individual’s Adjusted Gross Income (AGI), which could result in detrimental tax treatment of other transactions during the year. For example, investors with Modified Adjusted Gross Income over $250,000 will be subject to an extra 3.8% Medicare tax on net investment income. Thus, it is possible that recent changes to the tax laws may make a Roth IRA conversion less beneficial at this time than it was in prior years.

Furthermore, we currently have a historically high budget deficit and one of the primary ways for the government to reduce its deficit is through taxation. Therefore, it seems unlikely that income tax rates overall will be lower in the future.

Paying the Conversion Tax

Another key determinant when considering conversion is whether the investor has sufficient non-IRA funds that can be used to pay the conversion tax. In general, being able to pay the income taxes due as a result of conversion from taxable assets outside of the Traditional IRA is beneficial for several reasons. First, an individual who is under age 59½ at the time of conversion and who uses the Traditional IRA assets to pay the conversion tax would be assessed a 10% penalty on the portion of the distribution that is used to pay the tax (since the amount that is used to pay the tax is considered a distribution). In contrast, paying the conversion tax liability from an outside taxable portfolio would not only eliminate the 10% early withdrawal penalty, but would also provide an additional opportunity to, in essence, make a large contribution to the new Roth IRA. Consider the simple example of an individual with a $1 million Traditional IRA, a $350,000 taxable portfolio, and a 35% income tax rate. The income tax liability due to convert the portfolio would be $350,000 and using the taxable assets to pay the income taxes would leave the full $1 million portfolio to grow tax-free with no lifetime minimum distribution requirement.

Required Minimum Distributions (RMDs)

As was stated previously, individuals are not required to take lifetime RMDs from Roth IRAs, therefore increasing the potential for significant tax-advantaged wealth accumulation over the long term. As such, if a high net worth investor would otherwise not need to take withdrawals from their retirement portfolio, or if minimum distribution requirements are likely to force them to withdraw more than they would need to meet their living expenses, converting to a Roth IRA may be beneficial. Likewise, distributions from tax-deferred assets are considered taxable income. Therefore, RMDs from tax-deferred assets may result in a higher future effective income tax rate. Converting tax-deferred assets to a Roth IRA eliminates RMDs (or reduces them in the case of a partial conversion) and as a result, could permanently lower an individual’s future income tax rate.

Multi-Generational Wealth Transfers

The Roth IRA’s benefit of tax-free growth and withdrawals, as well as its lack of lifetime required minimum distributions, makes the Roth IRA a generally more attractive vehicle for transferring wealth to future generations than Traditional IRAs. Furthermore, when a high net worth individual converts a Traditional IRA to a Roth IRA, they are in a way pre-paying the income tax liability that their beneficiaries would otherwise incur if they were to inherit the Traditional IRA. In addition, converting to a Roth IRA would reduce the size of their overall estate, thus potentially reducing estate tax at death (if applicable).

Conversions of Non-Deductible Traditional
IRA Contributions

One situation where conversion to a Roth IRA may be most beneficial is for individuals that have non-deductible contributions to Traditional IRAs, since only the portion of the conversion which constitutes gains will be taxed. However, individuals should be aware that conversion income is taxed on a pro-rata basis, meaning that the cost basis (i.e., the portion which was not deducted when contributed) is aggregated across all Traditional IRAs, potentially limiting the benefit. Thus, individuals are unable to “pick” which IRAs they want to convert. Nevertheless, the ability to convert non-deductible contributions to Traditional IRAs opens up a window for high-earning individuals to, in essence, make contributions to Roth IRAs at this time even though they are over the income limits, since individuals can make non-deductible contributions to a Traditional IRA, and then shortly thereafter convert the amount to a Roth IRA.

Given each high net worth individual’s unique circumstances, there is no single right answer regarding whether converting a Traditional IRA to a Roth IRA will maximize the individual’s net worth. That said, Table 2 below describes general factors that may or may not support a Roth IRA conversion.

Conclusion

Both Traditional IRAs and Roth IRAs have benefits, and while converting may be appropriate for some high net worth individuals, it may not be appropriate for others. The preceding commentary incorporated numerous assumptions which have to be made by investors in order to determine whether conversion makes sense. Furthermore, while the above information was based on current laws and regulations, these too could change at any time.

For those high net worth individuals who believe that their situation supports converting their Traditional IRA to a Roth IRA, we recommend that you check with your tax professional to discuss the potential impact of the additional conversion income on your overall tax situation (including state tax issues) in the year of conversion.

¹Investors may contribute up to $5,500 of earned income to Traditional IRAs in 2014 (up to $6,500 if they are at least 50 years old). The contribution is tax-deductible if the investor or the investor’s spouse is not an active participant in their employer’s qualified retirement plan. However, the contribution is still at least partially tax-deductible for active plan participants who file individual tax returns and have Modified Adjusted Gross Income (MAGI) under $70,000, married active plan participants whose MAGI is under $116,000, and non-active participants (who have an active participant spouse) whose MAGI is under $191,000.

²Investors may contribute up to $5,500 of earned income to Roth IRAs in 2014 (up to $6,500 if they are at least 50 years old). The contribution is made with after-tax dollars. Individuals with MAGI over $129,000 and married taxpayers with MAGI over $191,000 may not contribute to Roth IRAs.

³For a withdrawal from a Roth IRA to be qualified, the account must have been established at least five years prior to the withdrawal and one of the following four criteria must be satisfied (i.e., the individual is over 59½, death, disability, or for a first-time home buyer up to $10,000). Furthermore, distributions of converted IRA assets are always income tax free, but may be assessed a 10% early withdrawal penalty.