Roth Conversion for Elderly Clients

Submitted by David MAURICE on Wed, 2014-11-05 16:16

I have a strong prospective client couple in their mid 70’s with substantial portion of their assets in TIRA account. He hates having to take the RMD’s for income that he does not need as they have high pension income.

I have suggested that he at least consider Roth conversions not necessarily for his taxable benefit but from the perspective of his heirs as there is little risk he will outlive his assets. His current broker has told him that ‘it doesn’t work for him’. He believes this means he’s not eligible or that the math doesn’t work out for him. I countered that he is certainly eligible and that his broker is limiting his analysis to his (the prospect’s) own tax situation and his longevity while ignoring the benefit to his heirs who he certainly cares about the impact for.

Can you offer me a simple, cogent and concise argument for such consideration while noting the potential downsides?



Submitted by Alan - IRA critic on Thu, 2014-11-06 04:52

  • It seems that alot of people hate taking RMDs when they do not need the money. But that does not change the basic consideration for conversions which is the tax rate paid for the conversions vs the tax rate paid later on if no conversions were done. For client’s like this who may have beneficiaries in a high tax bracket, it is certainly a valid consideration to factor in the beneficiary’s tax rates as if the clients were to live an additional 25 years. Estate taxes or inheritance taxes should also be considered if the gross estate is large enough since the taxes paid on the conversion will be eliminated from the gross estate.
  • Whether the client’s have long term care insurance is also a factor. If no insurance, the retained TIRA should be large enough to fund those expenses since most of the expense qualifies for itemization. That is much better than paying the taxes and then distributing from the Roth, unless the pension income is high enough to cover the LTC expense.
  • Conversions cannot occur until the current RMD is satisfied. Therefore, the marginal rate for the conversions could be quite high since the RMD is added to the conversion and pension income. This will increase the cost of the conversion and make it less likely that the conversions can be done at a rate that is equal or lower than the rates later without conversions.
  • Each conversion reduces future RMDs, but once future rates are reduced the value of additional conversions also reduces since they are done at a higher cost with a lesser future tax benefit. It will take some detailed analysis to determine if and how much to convert and there are really no calculators that factor together all the variables that may affect the net benefit. 

Submitted by David MAURICE on Fri, 2014-11-07 19:13

Thanks Alan. Very balanced and very helpful.

Submitted by Alex Marr on Mon, 2015-01-19 00:09

I believe that the statement “Conversions cannot occur until the current RMD is satisfied.” may not be entirely accurate. I was advised of this by one custodian but another custodian states that conversion to Roth is allowed before current RMD is satisfied as long as there is sufficient fund left in the IRA to cover RMD later in the same year. Both custodians are large mutual fund companies. Obviously there is a difference of opinion. I tried to find the answer in IRS Pub 590 but failed to find the answer there. I would appreciate Alan-iracritic quote the authority source of his opinion. Thank you.

Submitted by Alan - IRA critic on Mon, 2015-01-19 02:26

Neither actually correctly describes the situation. The first distribution in an RMD distribution year is deemed to apply to the RMD. Therefore, if the first distribution is converted, the RMD is still satisfied, but an RMD is not eligible for rollover and the conversion creates an excess contribution to the Roth IRA which must be removed. This can be done by recharacterization and re distribution of the RMD if in the same year, otherwise a corrective distribution is required to avoid 6% excise taxes on the excess contribution. In summary, the conversion CAN occur and the RMD is satisfied, but an excess contribution is created when the first distribution is a conversion.

Submitted by David Mertz on Mon, 2015-01-19 03:46

The statement “conversion to Roth is allowed before current RMD is satisfied as long as there is sufficient fund left in the IRA to cover RMD later in the same year” implies that the later distribution from the traditional IRA can be deemed to be the RMD.  This position is incorrect based on CFR § 1.402(c)-2 Q&A-7(a) which says, in part, “For example, if an employee is required under section 401(a)(9) to receive a required minimum distribution for a calendar year of $5,000 and the employee receives a total of $7,200 in that year, the first $5,000 distributed will be treated as the required minimum distribution and will not be an eligible rollover distribution and the remaining $2,200 will be an eligible rollover distribution if it otherwise qualifies.”  As Alan-iracritic said, doing the Roth conversion first results in the RMD being part of the money rolled over to the Roth IRA, and since an RMD is not eligible for rollover, the RMD amount becomes an excess contribution to the Roth IRA.  Granted, it’s unlikely that the IRS would detect a problem because the reporting to the IRS on Forms 1099-R and 5498 does not indicate the relative order of the transactions, but that doesn’t justify failing to comply with the tax code.

Submitted by Alex Marr on Mon, 2015-01-19 00:26

Sorry Alan-iracritic but I am taking another approach to the statement that “This will increase the cost of the conversion and make it less likely that the conversions can be done at a rate that is equal or lower than the rates later without conversions.” Given a rising equity market where most of the elder folks wealth may be invested and the decreasing Uniform Life value for RMD, there is a great chance that the RMD taken later in life may move the account holder into a higher tax bracket. In that scenario, doing a Roth IRA conversion when the market takes a momentary downturn can be a good strategy since the money will grow in the Roth rather than the regular IRA. I would like to see someone do a detail math analysis related to this scenario.

Submitted by Bruce Steiner on Thu, 2014-11-06 23:02

  • Assuming you have other money with which to pay the tax on the conversion, the Roth conversion generally makes sense to the extent you can convert at a tax rate less than, equal to, or not too much higher than the tax rate that would otherwise apply to the distributions.

 

  • For example, assume a constant 30% tax rate.  You have a $100 traditional IRA and $30 of other money.  You convert.  Now you have a $100 Roth IRA.  Over some period of time, it grows to $200, all of which is yours.  If you don’t convert, your $100 traditional IRA will grow to $200, or $140 after taxes.  However, your $30 taxable account won’t grow to $60, since the income and gains on it are taxable each year.  Over a long period of time, the benefit is substantial.

 

  • There are no required distributions from the Roth IRA during lifetime.  The benefit of this can be substantial.

 

  • Mid-70s isn’t elderly.  We’ve done Roth conversions for people much older than that.

 

  • Since the Roth conversion is generally beneficial, the burden should be on the broker to show why it wouldn’t be beneficial in this case.

 

  • Bruce Steiner, attorney, NYC, also admitted in NJ and FL

Submitted by David MAURICE on Fri, 2014-11-07 19:15

Thanks Bruce. 

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