Deciding Whether to Roll Over to a Roth IRA

It is impossible to reach a single conclusion that applies to all taxpayers when deciding whether to roll over a traditional IRA or qualified plan account into a Roth IRA. Whether it makes sense to trigger the resulting tax liability depends on factors such as how long the taxpayer intends to leave the funds in the Roth IRA, what the taxpayer’s tax rate is now and what it will be when withdrawals are taken, and whether the taxpayer will have to use the funds from the IRA or qualified plan account to pay the tax due at conversion. As with most tax planning alternatives, the practitioner should calculate the numbers before deciding on a particular strategy.

Taxpayers will generally benefit from converting funds to a Roth IRA if all of the following conditions apply:

• The taxpayer (or beneficiary) will not need to take withdrawals from the Roth IRA for at least 15 to 20 years;
• The taxpayer’s (or beneficiary’s) tax rates when withdrawals are taken are no less than they are at the time the conversion occurs; and
• The taxpayer can pay the tax due on the rollover with funds outside the IRA or qualified plan.

Other factors and practical considerations that should be addressed or discussed with the client include the following.

Paying the tax with funds outside the IRA or qualified plan is generally necessary to making the rollover economically beneficial. If a taxpayer does not have available funds, it is unlikely a rollover will make economic sense (because the funds withdrawn from the IRA or plan and used to pay the tax are subject to income tax and, in many instances, the 10% premature distribution penalty). Practically speaking, many taxpayers may not have outside funds available to pay the tax on a conversion that results in significant taxable income.

Income generated from a conversion may create unexpected tax consequences. For example, items sensitive to changes in adjusted gross income (AGI) (e.g., itemized deductions, the child credit, education credits, etc.) may be adversely affected because of the increase to AGI caused by the IRA conversion income.

Conversions may be particularly beneficial for wealthy taxpayers who plan to leave large IRA balances to beneficiaries. Because Roth IRAs are not subject to the pre-death required minimum distribution rules, the funds can continue to accumulate without taxes for beneficiaries.

A significant benefit of making a conversion, particularly for younger taxpayers, is the ability to withdraw the converted amount tax-free and penalty-free after the funds have been in the Roth IRA for at least five years. Because Roth withdrawals come first from contributions (including converted amounts), this effectively allows tax-free and penalty-free access to some IRA funds before age 59½. However, exceptions to the early withdrawal penalty when IRA funds are used for first-time home expenses and college costs give owners of traditional IRAs penalty-free access to funds when used for those purposes.

Projecting a taxpayer’s tax rates in retirement is particularly difficult when that time is 20 or 25 years in the future. Future tax analysis is further complicated by the focus on the current tax system and discussions in Congress on how to simplify and reshape it. If Congress abolishes or dramatically lowers the rates in our current income tax system and replaces or supplements the current system with a value-added tax or national sales tax, paying tax now on a conversion might be a mistake. Further, there is no guarantee that Congress will not change the tax-free status of Roth IRA withdrawals in the future, either directly or indirectly (e.g., as part of an alternative minimum tax computation); however, adverse political consequences may prevent such changes.

Taxpayers with deductions or credits that may otherwise go unused are good candidates for conversions because the conversion income may create little or no additional tax liability. For example, elderly persons with high medical expenses or individuals with expiring tax deductions, such as net operating loss carryovers, or expiring tax credits, such as an adoption or foreign tax credit, may benefit from a Roth conversion. The ability to undo or recharacterize all or part of the conversion after year end allows these taxpayers to control exactly how much income they want to generate from the conversion, depending on the actual deductions and credits claimed on their return.

Taxpayers who are college students or who have dependents who are college students and will be applying for financial aid need to consider the ramifications of including the income from the conversion in the Free Application for Federal Student Aid (FAFSA). While retirement assets are not included in the FAFSA, any income reported on the taxpayer’s return will be included and could affect the amount of financial aid the student will be eligible for.

Caution: Using funds from a traditional IRA or employer plan to pay the tax on the rollover will often result in a 10% premature distribution penalty on those funds. They are subject to income tax (except to the extent the distribution is attributable to nondeductible contributions) and a 10% premature distribution penalty, unless an exception applies (Sec. 72(t)). If the funds are withdrawn from the Roth IRA following the rollover, a 10% early distribution penalty applies if the withdrawal occurs during the five-year period following the rollover (Sec. 408A(d)(3)(F)).

Taxability of Social Security Benefits May Have an Impact

Taxpayers receiving Social Security benefits (or who expect to begin receiving them in the near future) who are considering converting to a Roth IRA should consider the effect of the conversion on the taxability of their Social Security benefits. If their Social Security benefits are already taxable up to the 85% limit because of their level of AGI, rolling over retirement funds into a Roth IRA will have no effect on the amount of taxable Social Security benefits.

Some taxpayers with Social Security benefits may actually be better off with a Roth rollover. The rollover will cause taxable income to increase for one year. However, subsequent taxable income should be less than it would otherwise be without the rollover. Not only will rolled over funds not be subject to the age 70½ minimum distribution rules, but any Roth withdrawals after the age 59½ and five-year requirements have been met are tax-free. Thus, taxpayers who are otherwise close to the Social Security taxability threshold without considering any IRA distributions could see less of their benefits subject to tax by rolling their IRA or employer retirement account funds into a Roth IRA.

Other Income Tax Issues to Consider

In addition to the direct impact a rollover has on the taxpayer’s taxable income in the year of the rollover, there may also be an indirect effect. Several AGI-sensitive tax benefits may not be available if income is over a certain level. Thus, in the year(s) in which the taxpayer’s income increases because of a rollover to a Roth IRA, benefits such as the child or education credits, the adoption credit, or the deduction for interest expense on a loan for higher education expenses may be limited or even lost.

Other items that could be adversely impacted by a jump in income include the $25,000 rental exception to the passive loss rules, the medical and miscellaneous deductions, and the ability to make certain types of IRA contributions.

Also, when evaluating the costs and benefits of a Roth conversion, planners should carefully consider future tax rates, as well as the potential effect of the 3.8% net investment income tax for some high-income taxpayers. Although net investment income does not include distributions from IRAs and qualified plans, distributions from traditional IRAs and qualified plans will increase the taxpayer’s modified AGI, which may be enough when combined with other income to exceed the threshold amounts. Threshold amounts are $250,000 for joint or surviving spouse returns, $125,000 for separate returns, and $200,000 in other cases (Sec. 1411(b) and Regs. Sec. 1.1411-2(d)(1)). Because distributions from Roth IRAs are not included in modified AGI, they cannot cause the 3.8% surtax on net investment income to apply.

Medicare Part B and Part D Premiums

Extra income from a Roth conversion may adversely impact the monthly Medicare Part B and Part D premiums paid by upper-income seniors. These higher-earning seniors pay a surcharge above the regular monthly Part B and Part D premiums based on their AGI. For 2016, the surcharge applies if 2014 modified AGI exceeded $85,000 for single filers and $170,000 for joint filers. The maximum Part B surcharge is 220% (based on the standard payment of $121.80) for single filers with a 2014 AGI above $214,000 and married filers exceeding $428,000 of AGI. The Part B surcharge can be as much as $268 per month in 2016. The Part D surcharge can be as much as $72.90 per month in 2016. So, seniors reporting income from a Roth conversion in 2016 could see their 2018 Medicare Part B and Part D premiums increase.

Observation: Many taxpayers will be able to pay less than $121.80 per month for Medicare Part B. Since Social Security beneficiaries received no cost-of-living adjustment this past year, taxpayers who received benefits and paid Medicare premiums in 2015 are subject to a lower rate of $104.90 per month in 2016.  

This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 17th edition (March 2016), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2016 (800-431-9025; tax.thomsonreuters.com).