Avoiding a big Roth conversion mistake

There is a downside to a Roth IRA conversion. Whether clients pay tax for 2010 or spread the tax burden between 2011 and 2012, they’ll still owe income tax on the pretax money they move from a traditional individual retirement account or company plan to a Roth IRA. The conversion income will be stacked on top of their other income and taxed at their highest marginal rate. If the two-year-payout deal is chosen, taxes will be paid at whatever rates are in effect in those years. Taxes for many will be lower in 2010.

One choice, of course, is to pay the tax with money from the traditional IRA. That’s generally not a good idea, though, for a number of reasons.

Suppose Richard has $1 million in his traditional IRA, all from pretax contributions, and is in a 35% tax bracket. If he converts the entire account to a Roth IRA, he will owe $350,000 in tax.

Where will Richard find $350,000? He might consider taking the money from his IRA to pay the tax bill. But after paying the tax, he would have only $650,000 in his Roth IRA for tax-free accumulation. In addition, if Richard later wants to undo (re-characterize) his $1 million Roth conversion, he will be able to re-characterize only the $650,000 that was actually converted to his Roth IRA. Depending on the performance of Richard’s investments and his overall desire to keep the funds in a Roth IRA, this could become a major drawback.

It gets worse. What if Richard is only 50 years old? In that case, he’ll probably owe an additional 10% early-withdrawal penalty (because he is not yet 591/2) on the money that he is not converting to the Roth and is using to pay the tax on the conversion.

Assuming that Richard can’t qualify for an exception to the 10% penalty, his $350,000 withdrawal to pay the conversion tax would generate an extra $35,000 of tax in the form of the penalty, leaving him just $615,000 of the original $1 million. Worse yet, he also would owe the 10% penalty on the $35,000 as well, continuing a vicious cycle of costly taxation.

Many clients don’t understand this. They know that a Roth IRA conversion is exempt from the early-withdrawal penalty, but they don’t see the difference between the amount actually converted and the amount withdrawn to pay the tax on a conversion.

How about using a different approach? What if Richard converts everything to the Roth IRA and then takes a distribution from the new Roth account to pay for the taxes? Will that work? Nope. The Internal Revenue Service and Congress don’t permit it.

While it’s true that if all $1 million of Richard’s IRA is converted to a Roth IRA, he will owe income tax but no penalty on the conversion, any withdrawals of the converted funds within five years of the conversion could trigger the 10% penalty.

The 10% penalty remains in effect until five years or until 591/2, whichever comes first. So if 50-year-old Richard converts to a Roth IRA in 2010, five years will come first, and he’ll owe the 10% penalty on any withdrawals before 2015. What’s more, each Roth IRA conversion triggers a new waiting period.

Suppose that Richard decides to do partial conversions, $100,000 per year for 10 years. The $100,000 he converts in 2010 will be penalty-free in 2015, the $100,000 he converts in 2011 will be penalty-free in 2016 and so on. Of course, by the time Richard converts the last $100,000 in 2019, he’ll have to wait only until he turns 591/2 to withdraw the converted funds penalty-free (since it is the sooner of five years or 591/2).

If Richard is 591/2 or older when he converts, there can never be a 10% penalty on future Roth withdrawals — which makes using the converted funds to pay the tax less taxing. But it still diminishes the ultimate value of the Roth IRA since not all the IRA funds will compound tax-free in the Roth. But this option is surely better than paying a 10% penalty.

If a client does not have enough non-IRA funds to pay the tax on a Roth conversion, the conversion generally isn’t worth it. In some cases, a conversion should be avoided altogether, while in other cases, converting smaller amounts may be the right move. Smaller annual conversions can still add up to big sums over time.

The most tax-efficient option is to find non-IRA cash to pay the tax on a Roth IRA conversion.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.