When clients should open or convert to a Roth IRA

Roth IRA accounts are frequently recommended by advisers but sometimes in what seems a cookie-cutter fashion, assuming everyone should open a Roth account and that everyone with a traditional IRA should convert it to a Roth at any time. In fact, however, whether a Roth is better for the client depends on multiple factors. This article addresses when and why a Roth account makes good sense, as well as best practices in the Roth conversion process. Using a Roth conversion most advantageously could generate a sizable after-tax return.

Roth IRA accounts are frequently touted for their tax benefits, primarily qualified distributions that are tax-free (Sec. 408A(d)(1)). Qualified distributions under Sec. 408A(d)(2)(A) are those paid or distributed after the five-year period beginning with the first tax year for which the individual (or spouse) first contributed to the Roth account established for that individual and are made either:

• On or after the taxpayer attains age 59½;
• To a beneficiary or the taxpayer’s estate on or after the taxpayer’s death;
• On account of the taxpayer’s disability; or
• For a first-time home purchase (up to $10,000).

Whether a Roth account makes sense depends on the taxpayer’s current tax rate compared with his or her expected tax rate in retirement, when distributions will generally be made. The CPA can discuss tax rates with the client, along with the types and sources of income the client has now and anticipates later. Obviously, a big unknown is what future statutory tax rates will be. One could argue that, historically, tax rates are lower than in the past, and, therefore, they likely will only go up. However, one also has to consider that the higher rates were in effect before passive activity loss or at-risk rules were enacted and that no one knows what future rates will be.

Generally, if a client’s tax rate is expected to be much higher in his or her retirement years, a Roth account can provide value. The distributions will already have been taxed when initially contributed or converted to the Roth account. Unfortunately, however, the taxpayer may view the analysis as a cash flow issue. The Roth will provide no current tax benefit via a deferral of current income tax on contributions. If an individual anticipates being in a significantly higher tax bracket later in life, then it would be best to forgo a current-year tax deduction, such as that provided by a pretax retirement account contribution (e.g., to a Sec. 401(k) account or a traditional IRA) and to make Roth contributions or a conversion.

Therefore, Roth accounts cannot be recommended across the board; every client’s needs and resources must be analyzed. Most financial planning scenarios anticipate that individuals will live in retirement on perhaps 70% to 80% of their preretirement income and will have a lower tax rate. For them, a Roth account might not make sense.

Other factors include the type of income received or expected in retirement, such as qualified dividends or tax-exempt interest. In addition, Roth IRAs are not subject to required minimum distributions (RMDs), so these accounts can grow far into retirement. Note, however, that designated Roth accounts (“Roth 401(k)s”) are subject to RMDs; therefore, a Roth 401(k) should be rolled over into a Roth IRA to avoid the RMD rules.

Time-value-of-money concepts can help reinforce with clients the need to analyze Roth account planning.

Example: Assume a 30-year-old has no retirement plan currently at work, so a traditional IRA contribution can provide an adjustment to arrive at adjusted gross income (AGI) in calculating his tax liability. He saves $100 every month and wants to put a year’s worth of these savings ($1,200) into either a Roth account or a traditional IRA, along with the current-year tax savings he will realize from making a contribution to a traditional IRA. The taxpayer will not make any distributions from the account he contributes to for 30 years, and it will earn 5% annually. Table 1 compares the future value of the investment in a traditional IRA versus a Roth account where the taxpayer has a constant tax rate throughout the entire period of investment and retirement of 30%.

Table 1 shows that with all things remaining equal, including current and future tax rates, it makes no difference in which type of account the taxpayer’s retirement contribution resides; both the Roth account and the traditional IRA have the same future value.

Next, in Table 2, assume the same conditions as in Table 1, but with a current tax rate of 30% and a tax rate in retirement of 40%.

Table 2 shows that with a higher tax rate during retirement, the taxpayer comes out ahead with a Roth account. Next, Table 3 shows the reverse, with a current tax rate of 40% and a tax rate in retirement of 30%, resulting in a higher future value for a traditional IRA.

Comparing a traditional and a Roth IRA can suggest another consideration when a taxpayer wants to contribute the maximum amount into a traditional IRA or a Roth account. For 2015 and 2016, the maximum contribution is $5,500 (or, for an employer plan, 100% of compensation includible in gross income, if less) or $6,500 for taxpayers age 50 and older. The tax benefit from the IRA deduction can be invested in an ancillary taxable investment account. Here, the tax benefit cannot be included in the IRA account (growing tax-deferred) because the maximum annual contribution was made. With a 30% tax rate, an extra $2,357 would be invested in a separate, taxable account ($5,500 ÷ (1 − 0.30) = $7,857; $7857 − $5,500 = $2,357).

This aspect of a Roth analysis may only apply to Roth IRAs vs. traditional IRAs and not to Roth 401(k)s vs. traditional 401(k)s. This is because the IRA can provide a tax benefit in the form of an above-the-line adjustment in determining AGI, which may help provide a refund for the taxpayer, which in turn may yield a cash lump sum (tax refund) to invest, while the 401(k) tax benefit would be realized in each paycheck in an amount that would have to be set aside for investment. In either case, this strategy is often burdensome and usually not cost-effective for the CPA and the investment adviser to plan and analyze. This additional investment strategy also requires considering the investments chosen and taxes due on the investment results.

ROTH CONVERSIONS

Amounts in a traditional IRA may be converted into a Roth IRA by a trustee-to-trustee transfer, by a transfer to a Roth account maintained by the same trustee, or by a rollover contribution within 60 days of a distribution. The portion of the distribution or transfer that is not treated as a return of after-tax contributions to the traditional IRA is added to gross income in the year of the conversion and thus is subject to income tax but not the 10% additional tax under Sec. 72(t).

Roth conversions often seek to take advantage of the taxpayer’s current (lower) tax rate and market conditions affecting the account’s value. In addition, Roth accounts are intended for use in retirement and should be given time to grow and allow interest and appreciation to compound. Conversions done too close to retirement may not provide much value. Clients converting to a Roth also need to consider how to pay the additional taxes due.

One example of when a Roth conversion works well and can provide a substantial tax benefit is when the taxpayer starts a new business and anticipates losses or substantially lower income, which may result in little or no tax liability on the conversion.

Sometimes the taxpayer may be reluctant to go through with the conversion because of a dismal economic outlook. To pay tax on the fair market value of the account and later have the account value decline will only leave the taxpayer regretful. To help protect the taxpayer from this unfavorable result, the CPA could advise setting up separate Roth IRA accounts for each investment category or sector and converting separate amounts into their own respective accounts, thus allowing a taxpayer to take maximum advantage of his or her ability to recharacterize IRA contributions (including conversion contributions).

RECHARACTERIZING CONTRIBUTIONS

Taxpayers are permitted to recharacterize IRA contributions, that is, change their nature to or from Roth or traditional (Sec. 408A(d)(6) and Regs. Sec. 1.408A-5, Q-1). If the client implements the strategy described in the preceding paragraph and a Roth account in a particular investment sector does not perform well, the taxpayer can recharacterize the contribution to that account back to a traditional IRA account. A rollover from an employer-sponsored retirement plan to a Roth IRA cannot be recharacterized back to the employer’s account; it would have to be transferred to a new or existing traditional IRA.

Recharacterizations can be done as late as the extended due date for the return for the year the contribution was made (Sec. 408A(d)(7)). For example, a taxpayer who made a Roth conversion for 2015 in January 2015 could recharacterize it as late as Oct. 15, 2016 (assuming he or she has timely filed a return, i.e., filed a return by the unextended due date or filed an extension and filed a return by the extended due date). Clients who have filed timely 2015 returns before recharacterizing a conversion may recharacterize the conversion by Oct. 15, 2016, if they file an amended return for the year (on or before the due date for amended returns). For many investors, 2015 did not provide much of a return, and there may indeed be some regrets for 2015 conversions.

A taxpayer may reconvert contributions recharacterized from a Roth to a traditional IRA back to a Roth IRA again. However, the taxpayer must wait until the later of (1) 30 days after the recharacterization or (2) the beginning of the tax year following the first Roth conversion (Regs. Sec. 1.408A-5, Q-9).

VALUE AND FLEXIBILITY

Thus, Roth accounts can provide value and flexibility for the client, but only if they are established and maintained in the most advantageous way. With the right tools and approach, CPA advisers can analyze clients’ circumstances, needs, and resources to fashion a retirement plan that may, if indicated, make use of a Roth IRA, either through regular contributions or a conversion.   

About the author

David M. Barral (dbarral@mbafcpa.com) is a tax and accounting supervisor with MBAF CPAs LLC in New York City. He specializes in tax compliance and advisory services for individuals.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

AICPA RESOURCES

The Tax Adviser article

• “Roth IRA Planning,” March 2016, page 202

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• Planning for Retirement Needs, 13th edition (#PPF1507P, paperback)
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• Cutting Your Client’s Tax Bill: Individual Tax Planning Tips and Strategies (#732191, text; #163651, one-year online access)

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• Sophisticated Tax Planning for Your Wealthy Clients, Nov. 10—11, Boston
• Personal Financial Planning Summit, Jan. 22—25, Rancho Palos Verdes, Calif.

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