In 1997, the U.S. Congress established a new type of retirement account named after Senator William Roth. Although this account did not provide an immediate tax deduction, it did offer a powerful and simple concept– all growth, if kept until retirement age, would be TAX-FREE. For many years, higher income Americans were unable to participate in either annual Roth contributions or Roth conversions due to income limits of the account. In 2006, because of the Pension Protection Act (PPA), employers began to amend their 401(k) & 403(b) plans to include Roth contributions without income restrictions, and in 2010, the income limit was lifted for Roth conversions. So with this newfound Roth freedom, what planning opportunities are available to maximize investment and tax value?

The reasons for Roth conversions can vary widely; some strategies are more appropriate for high net worth individuals, while others can help people of very modest means. Let us explore some of these strategies and see which ones might be applicable to your situation.

Income Smoothing

When you have a year or period of years where you anticipate lower earned income, Roth conversions can help smooth out the annual income number to take advantage of lower income tax brackets in low earning years.

For example, if someone goes back to school, takes time off of work, or retires before pensions and Social Security payments begin, Roth conversions can raise income during the low earning years to take advantage of marginal rates which could be much lower than if that income is paid out of the IRA at a later date on top of other income.

“Back Door” Roth Contributions

Though high income earners are not allowed to contribute to Roth IRA accounts annually, there is no income limit on making non-deductible IRA contributions. There is also no income limit on making Roth conversions. Thus, high income earners can make non-deductible contributions and immediately convert them to Roth accounts. Since there is no gain and no deduction was taken on the contribution, the conversion produces no taxable income.  It is a “back door” to making Roth contributions.

The major hurdle to this strategy is that if an individual has a traditional, SEP, or SIMPLE IRA, he must aggregate all accounts together to calculate the taxable portion. So if you have $5,000 in a non deductible IRA, $45,000 in an IRA and make a $5,000 conversion, regardless of which account you convert, only 10% ($5,000 of $50,000 total) will be considered tax free on the conversion. Accounts are aggregated by individual, so a spouse without an IRA could still benefit from this strategy even if the other spouse has an existing IRA.

Increase Retirement Savings

Take, for instance, a $1,000,000 traditional IRA example. After paying tax (35%) on the distributions, the value may only be $650,000 after Uncle Sam gets his share.  If that IRA is converted to a Roth, then the balance is still $1,000,000, but because the Roth is tax-free, the value to the owner is much higher than it was before. 

In this example, the conversion has boiled down to a large $350,000 retirement plan contribution from after-tax assets. The Roth has a higher value than the traditional IRA but no annual contribution limits were used for the conversion. Just like an employee defers taxable income to fund an IRA, the conversion uses after-tax assets to fund the conversion and increase the value of the retirement account.

Social Security Taxation Avoidance

Many modest income retirees can find themselves in a tax squeeze involving Social Security benefits. Social Security is only taxable if other sources of income are high enough to exceed specific thresholds. Once that income threshold is crossed, Social Security income, which would not have been taxable, is made taxable by other income sources.

To illustrate, a retiree may have Social Security benefits of $2,000 per month, have no pension, but have a traditional IRA he can draw on for extra income.  If he draws nothing from his IRA, he pays $0 in tax on his Social Security benefits. If he draws $3,000 per month from his IRA to live on, then 85% of the Social Security benefits become taxable.  Therefore when calculating taxes, 85% of the Social Security benefits are added into the $36,000 of IRA distributions, for total taxable income of $56,400 per year in this example.

The retiree is only adding $3,000 to his monthly income, but is paying income tax on $4,700 because 85% of his Social Security becomes taxable. It is not uncommon for retirees to face up to 40% effective tax for taking IRA distributions in this modest income range.  Even if the retiree doesn’t need to take additional distributions from an IRA, at 70 ½, all taxpayers are required to take Required Minimum Distributions (RMD’s) from their traditional IRA accounts, which could push someone into this territory.

Roth IRA distributions, on the other hand, are not counted as income for this calculation, and RMDs are not required for Roth IRAs. You are not forced to take taxable income in the future and when you do take distributions; it will not subject your Social Security to being taxable.

Estate Shrinkage

For those facing a possible estate tax, a Roth conversion can shrink the size of a taxable estate, but not decrease the value of the estate. Take, for instance, the same $1,000,000 traditional IRA example used previously. If that IRA is converted to a Roth, then the balance for estate tax purposes is still $1,000,000.

The conversion creates a large tax bill which will be paid with other assets. By “pre-paying” the tax on the IRA, those other assets (used to pay the tax) have been removed from the estate. The Roth IRA is now after-tax and worth more than the $1,000,000 traditional IRA by approximately the tax paid on the conversion. If estate tax is a problem, paying income tax once is better than paying estate tax and then having the beneficiaries pay income tax when they withdraw the asset.

No matter what your situation, it may make sense to look at Roth conversions. Some strategies take years to execute, some can be performed in one quick conversion. You should look carefully at your situation and consider if Roth conversions make sense for you.