Forensic, General & Medical
Expert Witnesses

Affluent Should Consider Roth Conversions

     By Fulcrum Inquiry Damages, Appraisal, Accounting & Economics Expert Witnesses

PhoneCall David Nolte at (213) 787-4100

Expert Witness: Fulcrum Inquiry
Starting in 2010, affluent taxpayers can convert assets from a traditional IRA to a Roth IRA. We review the various factors that should be addressed in making this decision. Many affluent taxpayers should take advantage of this in 2010.
Starting in 2010, taxpayers at any income level can convert regular IRAs to Roth accounts. Roth accounts have easy-to-understand advantages and disadvantages. Roth advantages include tax-free income and no required minimum distributions. But, taxes must be paid on all initial contributions to a Roth account, including immediate additional taxation on conversions from a regular IRA. In contrast, regular IRAs obtain a tax deduction at the time moneys are first contributed, but all amounts later received from the account are taxed at ordinary tax rates.

Before 2010, taxpayers with adjusted gross incomes of over $100,000 have been unable to convert assets from a traditional IRA to a Roth IRA. Starting in 2010, this restriction disappears. Anyone desiring to convert traditional IRA to a Roth IRA must pay taxes (at ordinary income rates) on the full amount converted. Once converted, Roth amounts are income tax-free, including all amounts of accumulated income earned.

The Roth conversion opportunity is not limited to current IRA accounts. Here are some other sources to consider:

1. If you have a 401(k) or any other retirement plans from a previous employer, those can also be rolled over to an IRA, and then converted to a Roth plan.

2. Some 401(k) plans allow employer contributions (usually just those that are already vested) to be rolled over to an individual IRA. This is a plan-specific provision that your employer may not have adopted, so you will need to check. If your current employer’s plan contains such a provision, these 401(k) amounts could be converted to an IRA, and then converted to a Roth plan.

Because we do not know what future tax rates will be, the decision to convert to a Roth account is inherently risky. The starting point for deciding whether to contribute or to convert to a Roth IRA is a forecast of what future tax rates will be like for that taxpayer. If tax rates are going to be lower in retirement than currently, once might be better with a regular 401(k) or IRA. The reverse is also true. Accordingly, because the affluent are already in the highest brackets, very high-income taxpayers are the least likely to benefit from a Roth conversion purely because of tax rate differences.

However, there are significant other factors which might favor the use of a Roth account that are not calculated simply as tax savings using current tax rates. For many high-income taxpayers, these attributes are the more important reason for converting to a Roth account. These benefits include:

1. The tax equivalency described above occurs only when the taxpayer reduces the amount invested by the taxes which are paid currently. When a taxpayer can contribute or convert the maximum amount to a Roth IRA or 401(k), and use money from an otherwise taxable account to pay the tax liability, the taxpayer can shelter a larger amount of money. In this situation, the taxpayer uses otherwise taxed investment funds to pay the taxes, and thereby increases the amount of investment funds that are permanently tax sheltered.

2. Similar to the preceding point, the Roth account protects a greater amount of purchasing power from creditors’ claims. However, see the cautions at the end of this article regarding possible asset protection limitations. Moneys that can be received tax free are worth more than the same amount from a regular IRA from which taxes must then be paid. Consequently, the economic value of protected assets using a Roth account is increased, particularly when the income taxes are paid separately with taxable accounts.

3. Roth accounts do not face required minimum distributions while the original owner and his/her spouse are alive. This provides a taxpayer the flexibility to continue to earn tax-free income for a longer period. By itself, this benefit is relatively modest unless the taxpayer lives substantially longer than age 70 ½. However, if the Roth account is passed as an inheritance, the heirs also receive the Roth moneys free of income taxes. Required minimum distributions begin at the point of inheritance based on the heir’s actuarial expected life. Consequently, inheritances of Roth accounts are far more valuable to the heirs than other assets that will generate taxable income, particularly for those heirs who are young and who therefore have smaller required minimum distributions.

4. One should not assume that tax rates will be less in retirement. For example:

a. An affluent retirement requires a large retirement nest egg that generates additional income. It is conceivable that many affluent persons will remain in a high tax bracket in retirement simply because of investment returns. Of course, this varies based on the level of affluence obtained.

b. Because of America's growing social welfare obligations for Medicare and Social Security, combined with the already high federal deficits, it is unlikely that there will be lower income taxes for the affluent in the future.

5. Because regular IRA (or 401(k)) distributions are part of the income base used to determine whether Social Security benefits are taxed, the Roth account does not worsen the challenge of keeping Social Security benefits from being taxed.

These Roth advantages provide an overall benefit even if future tax rates are slightly lower. However, regardless of the above advantages, if the taxpayer’s future tax rate is expected to decline substantially, the Roth conversion will not be beneficial.

Flexibility when to make Conversions (and to Change your Mind)

The entire regular IRA account need not be converted all at once, leaving the taxpayer to control how much, if any, should be converted in any year. For example, a taxpayer might convert just the amount necessary to fill up the 25% tax bracket, which is approximately $137,000 of taxable income in 2009. This approach opportunistically fills the lower tax brackets in years where income is less, cutting off any Roth conversion at or before one reaches the higher tax brackets.

A Roth conversion can be reversed as long as this occurs before the due date of the tax return for the tax year in question, including extensions. If reversed, it is as if the conversion never occurred. This provides an opportunity to use hindsight to avoid taxation, particularly for larger accounts where the extra administrative effort described below is worth the potential savings. Here is an example. On January 1, 2010, a taxpayer could divide a regular IRA into multiple Roth accounts, with each Roth account holding a different type of asset. Income tax would be due based on the value of each account on that date. Because of extensions to file, the 2010 tax return could be filed as late as October 15, 2011, more than 21 months later. The appreciation in each of the accounts that rise in value from January 1, 2010 is free of income tax.

However, assume that one of the individual accounts falls in value. In such event, the prospective Roth conversion for this account causes taxes to be incurred on value (as of the January 1, 2010 conversion date) that no longer exists. Roth accounts that have declined in value can be reversed back to their original status, and the income tax not paid as if the transaction never occurred. The entire process could begin again on January 1, 2012 (the required waiting period is 31 days), but now with the lower starting taxable value.

To engage this process, the custodians of the accounts must be notified in writing of the change(s) and the nature of the accounts. To avoid complicated calculations on a Roth recharacterization back to a regular IRA, no other Roth funds should be commingled with any moneys for which a decision might be made to reverse the conversion. Once a decision is made to permanently keep moneys as a Roth, then the individual permanent Roth accounts can be merged into a single account for administrative convenience.

There is a one-time opportunity in 2010 to allow the taxpayer to spread the income from the conversion equally over the next two years, in 2011 and 2012. However, one should be skeptical of what might at first seem to be an advantage to defer income. Current income tax rates are scheduled to sunset at the end of 2010, with a restatement back to the early-2001 higher tax rates. Assuming the Obama administration and the Democratic-controlled Congress do not increase tax rates for 2010 (instead of waiting for the old rates to occur on their own), tax rates for affluent taxpayers will likely be higher in 2011 and 2012.

For a Roth account to have its intended benefit, the taxpayer must be willing to hold the account for five years. This is not usually a problem, since these are long-term retirement funds. If withdrawals do occur before five years, the withdrawals from a Roth account are treated as first coming from the investment principle invested, and do not generate taxable income. Once the Roth contributions are fully withdrawn, subsequent distributions are from the growth in the Roth account. For this growth to not be taxed, the taxpayer must generally (i) have had the amounts in the Roth account for the first day of the fifth year after the year the Roth IRA was set up, and (ii) the taxpayer must be either over age 591/2, be disabled, or have died. If these rules are not met, the withdrawal of growth will be taxable at ordinary income rates; penalties may also occur.

Asset Protection Considerations

Asset protections should be considered before removing moneys from a 401(k) to an IRA.

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, bankruptcy law was simplified as it pertains to IRAs and ERISA plans such as 401(k)s. Under this 2005 law, Section 522(d) (12) provides that ERISA plans (such as a 401(k) that has employee funds) are exempt from claims by creditors. This same 2005 Bankruptcy law added Section 522(n) to the bankruptcy exemptions. It provides that IRAs (both regular and Roth) are exempt from creditor claims up to $1 million. The $1 million exemption is adjusted every three years for inflation by Section 104; consequently, for bankruptcy cases filed after April 1, 2007, the protection has been increased to $1,095,000.

However, rollover 401(k) accounts are not limited. Section 522(n) follows:

“For assets in individual retirement accounts described in [Sections of the Internal Revenue Code] … the aggregate value of such assets exempted under this section, without regard to amounts attributable to rollover contributions under [Sections of the Internal Revenue Code] … and earnings thereon, shall not exceed $1,000,000 .”

A plain reading of this leads one to the conclusion that rollover amounts from an ERISA account will maintain its unlimited protection from creditor claims in bankruptcy. A few commentators disagree, although the author is not aware of any post-2005 case authority that limits the exemption of a rollover IRA account over $1 million in a bankruptcy. To avoid complication involving commingled IRA that are both rolled over and not rolled over, rolled-over IRA accounts should not be commingled with other IRA accounts.

As long as bankruptcy protection is sought, these federal limits apply, regardless of the state involved. However, federal bankruptcy law does not override state law relating to IRAs in either state court proceedings or in non-bankruptcy federal proceedings. In California, for example, IRAs and qualified accounts are not given as much protection as occurs under certain other states. In California, the protection from creditors is subject to the "means test" of CCP 704.115 that will leave most debtors uncomfortable in retirement. However, in McMullen vs. Haycock (2007) 147 Cal.App.4th 753, the Court addressed a common fact situation in which a holder of 401(k) funds rolled such moneys to an IRA. The Court found that:

“We conclude that because California law permits the tracing of exempt funds (Section 703.080, subd. (a)), the mere transfer of the fully exempt private retirement plan assets to the IRA did not necessarily eliminate their full exemption under Section 704.115, subdivisions (b) and (d). “

Although not a straight-forward decision, a Roth IRA conversion deserves serious consideration by most affluent taxpayers.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

Copyright Fulcrum Inquiry

More information about Fulcrum Inquiry

While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.
For specific technical or legal advice on the information provided and related topics, please contact the author.

Find an Expert Witness