Longer Lifespans Strengthen Case for Roth Conversions

Converting a traditional IRA to a Roth IRA can offer powerful benefits, but it requires consideration of several factors. While Roth conversions are more commonly a planning device for individuals still in their active earning years, the strategy may be valuable to retirees who have not fully considered the tax impact of required minimum distributions (RMDs) from their traditional IRA accounts.

While most CPAs advise against paying a tax today that can be deferred until tomorrow, Roth conversions can be the exception to this rule. The tax advantages of owning a Roth versus a traditional IRA make the case for a conversion compelling when future tax rates will be the same or higher than today's and a long time horizon is involved.

Since today's retirees are living much longer, longer post-retirement time horizons must be considered. According to data compiled by the Social Security Administration, about one out of every four 65-year-olds today will live past age 90, and one out of 10 will live past age 95.

Many CPA financial planners recommend that, when possible, clients take advantage of the 8% annual increase in benefits awarded to those who wait until age 70 to collect Social Security. For those who are retiring at their full retirement age (FRA) of 66 or 67 but may be waiting to collect until age 70, a Roth conversion is an attractive way to help stretch retirement dollars by smoothing out tax rates.

The advantages to retirees are:

• Tax-free income from the Roth once the five-year holding requirement has been satisfied.
• Flexibility in the timing of future income. RMDs are triggered on traditional IRAs at age 70½, but RMDs do not apply to Roth IRAs.
• Potentially lower taxes on Social Security benefits, since qualified Roth IRA distributions are not included in income for purposes of calculating taxable Social Security benefits.
• Reduced net investment income tax. Qualified Roth distributions are not included in either net investment income or in the modified adjusted gross income calculation for assessing the 3.8% net investment income tax.

When to Consider a Roth Conversion for a Retiree

If the answers to the following questions are all "yes," then a Roth conversion should be considered:

1. Does the client have cash outside a traditional IRA account to cover the tax bill for a conversion?
2. Does the client have at least a five-year time horizon before distributions from the Roth IRA will be needed?
3. Is the client's future tax bracket estimated to be the same or higher than it is today?

For many retirees, the answer to the last question is "yes." Even assuming that the client's Social Security income and other retirement income sources will not change, RMDs from IRA balances can drastically increase taxable income. It is also important to consider that one spouse is likely to die sooner than the other, changing the remaining spouse's filing status to single in later years.

If a CPA is unsure about the client's future tax bracket, help is on the way. The AICPA's Tax Rate Evaluator spreadsheet developed by Robert Keebler, CPA, makes it easy to evaluate future tax rates for retirees. (For more information about accessing the Tax Rate Evaluator, see the sidebar, "PFP Section Resources" at the end of this article.) With basic inputs from the front page of the client's Form 1040, U.S. Individual Income Tax Return, and Schedule A, Itemized Deductions, the evaluator models different IRA conversion scenarios with relative ease. It calculates the projected tax liability, the marginal tax bracket, and whether conversions might trigger unintended consequences such as the alternative minimum tax (AMT). It is easy to experiment with the model, which also projects RMDs from the balance of the IRA that is not converted. A 15-year projection summary provides detailed data.

Example: A married couple just retired at age 66 and are collecting only a spousal Social Security benefit of $15,000 per year until the primary earner turns age 70, when their total Social Security Income will increase to $57,400. At that same time, their mortgage will be paid off, reducing their itemized deductions by $8,500 per year. They have $1 million in a traditional IRA and $500,000 in their after-tax savings account. With annual after-tax expenses of $100,000 and reduced itemized deductions, their retirement budget could be tight in later years, particularly if long-term-care expenses have not been insured.

A practitioner could help the couple by recommending that they spend their after-tax savings first while also making a $50,000 Roth conversion in each of the next four years, saving tax dollars going forward. Using the Tax Rate Evaluator's IRA Distribution Calculator, one can see that their taxes in future years will decline due to the Roth conversions. During the next 15 years, they would save a total of $17,460 in taxes.

Recharacterization Considerations

Recharacterization rules allow the complete reversal of a Roth conversion if it is completed by the timely filing of the client's tax return for the year of the conversion. This generally means extending the return to an Oct. 15 filing date to provide maximum flexibility. A recharacterization is merely a reversal of the earlier transaction. Dollars that were transferred from a traditional IRA to a Roth IRA can be placed back into a traditional IRA by a trustee-to-trustee transfer as though the earlier transfer had never happened.

A recharacterization is valuable for clients in certain circumstances. In the perfect situation, the IRA dollars are moved from the traditional IRA account to the Roth account in January of year 1. By October of year 2, the recharacterization deadline, much more information is available about the client's tax situation for that year. Even if the client's tax situation is unchanged, market values may have changed. If the value of the Roth account has declined significantly due to market fluctuations, it would make sense to reverse the transaction and reconvert it at the lower value.

The following factors must be carefully considered:

• When one is recharacterizing an IRA, it is best to set up an entirely new traditional IRA account. This preserves flexibility going forward if Roth conversions are anticipated to occur over several years.
• Plan to recharacterize the entire Roth account rather than doing a partial recharacterization.
• There is a waiting period on recharacterized amounts before they can be reconverted. If a taxpayer recharacterizes all or part of a rollover or conversion to a Roth IRA, he or she cannot reconvert the amount recharacterized to the same or another Roth IRA until the later of 30 days after the recharacterization or the beginning of the year following the year of the rollover or conversion.

Practical Implementation of a Roth Conversion

One option for implementing a Roth conversion is to use Keebler's approach of taking full advantage of recharacterization opportunities by establishing multiple Roth accounts and converting each unique asset class or investment type in the traditional IRA to a unique Roth IRA account. For IRAs with large asset holdings, the rewards of this approach could be worth the complexity, since the more Roth accounts that are established, the greater the flexibility in recharacterization. But the practical implications of establishing five or more Roth accounts and staying on top of recharacterization and reconversion deadlines can make this approach intimidating.

A simpler approach is to recommend conversion to just two Roth accounts: one to hold fixed income (bonds) and the other to hold equities (stocks). Since bond values tend to move inversely to stock values, this provides a simple yet advantageous way to assess recharacterization opportunities.

The following checklist will help practitioners determine whether a retiree client may be a good candidate for a Roth conversion:

1. Determine whether the client is a candidate for Roth conversion by considering the following factors:
   1. There are funds outside the traditional IRA to cover taxes.
   2. The client can wait for the required five years before taking Roth distributions. It is important to note that with respect to conversions, the five-year clock starts anew for each conversion.
   3. The client's future tax bracket will be the same or higher than today.
2. At the beginning of the year (optimal) or any time during the year, establish two new Roth IRA accounts.
3. At the beginning of the year (optimal) or any time during the year, convert bonds to one Roth account and equities to the other.
4. Pay estimated taxes on the value of the accounts converted.
5. If a Roth account's value declines significantly prior to the extended filing deadline for the tax return (Oct. 15 of the following year), recharacterize the account and file for a refund.

PFP Section Resources

The AICPA Personal Financial Planning (PFP) Section provides significant resources to help CPAs assist clients with retirement planning and Roth conversions. PFP Section members, inclusive of Personal Financial Specialist (PFS) credential holders, have access to a simple Roth conversion calculator from CPA Robert Keebler, webcast recordings, reference charts, and more at aicpa.org/pfp/roth. PFP Section members also have access to the bronze edition of Keebler's Tax Rate Evaluator software mentioned in this column and receive a 10% discount on the purchase of the gold edition of the software. More information about the software and the differences between the bronze and gold editions is available here.  The PFP Section's Retirement Planning resources page includes guides on Social Security and retirement health care planning as well as information on safe withdrawal rates, long-term-care planning, and more. In addition, membership in the PFP Section includes access to Forefield Advisor, which provides clear and concise consumer-oriented materials on many of these topics with special resource centers for Social Security and health care reform. CPAs who specialize in providing tax, estate, retirement, risk management, and/or investment planning to individuals, families, and business owners may be interested in applying for the PFS credential. CPAs can demonstrate their confidence and competence in these PFP disciplines through experience, education, examination, and a resulting credential. Information about the PFS credential is available at aicpa.org/PFS.

Contributors

Theodore Sarenski is president and CEO of Blue Ocean Strategic Capital LLC in Syracuse, N.Y. Gina Chironis is the CEO of Clarity Wealth Management in Irvine, Calif., and is a member of the AICPA Personal Financial Planning (PFP) Executive Committee. Mr. Sarenski is chairman of the AICPA PFP Executive Committee's Elder Planning Task Force and is a member of the AICPA Advanced PFP Conference Committee and PFP Executive Committee Thought Leadership Task Force. For more information about this column, contact Ms. Chironis at gina@claritywealth.net.