Foster Group

Have you wondered whether a Roth IRA conversion is something you should consider?  In the past several months, we've had numerous discussions with clients regarding Roth IRA conversions, and whether this makes sense for them. 

We've also written on the merits of conversion, and why it's important to evaluate this closely before proceeding:  http://www.fostergrp.com/assets/fostergroup/RothIRAConversion.pdf.  In one of our recent Wise Wealth Lecture Series events, Kent Kramer provided a fantastic overview of how and why the new rules on conversion came into existence, why a conversion may not be so black and white, and some brief examples of how the math behind conversion actually works.  Kent's presentation is available here:  http://www.fostergrp.com/resource-center/wise-wealth-lecture/kent-roth-ira.

The variables influencing this analysis are really limitless, but it almost always hinges on comparing the taxes you will pay today (to convert) to the taxes you expect to pay in the future when you withdraw dollars from the IRA (if you don't convert) - which brings us to the point of this blog.  If, in retirement, you have charitable gifts, medical bills, long-term care expenses, mortgage interest or property taxes, the tax-deductibility of these items could be lost or minimized without income to support the deductions.  Let's use one of these as an example to illustrate:  

Let's say I have an elderly friend who is forced to enter a long-term care facility which charges $200 per day, or $73,000 annually, for his care.  Let's also assume the entire $73,000 is paid by withdrawals from his IRA, requiring him to recognize this as income.  However, because long-term care expenses are considered deductible medical expenses, he can deduct these expenses to the degree that they exceed 7.5% of his adjusted gross income.  So of the $73,000 withdrawn from the IRA, only $5,475 remains taxable.  His personal exemption amount of $3,650 {for 2010} further reduces his taxable income to $1,825, putting him in the 10% tax bracket and incurring a tax liability of $182.50 {or 0.25% of $73,000}.

As a comparison, someone in the 33% federal and 8.98% (Iowa) state tax brackets would incur a tax liability of $30,645.40 in 2010 to convert this same $73,000 to a Roth IRA {or 41.98%}. 

For those who are charitably inclined, there may be an even greater cost of converting IRA assets to a Roth.  Charities can be named as beneficiaries of traditional IRA assets, essentially converting them to 'non-taxed' dollars at your death, to the charity of choice.

To be clear, there are certainly circumstances that warrant the conversion of IRA assets to a Roth.  We've seen several that are virtual 'no brainers'.  However, the tax liability from eventual withdrawals from your IRA may not be as much as you think.