Help an IRA newbie convince my dad to ROTH convert?
Hi, I’m a newbie to understanding the intricacies of IRAs and ROTH conversions, but I do know some math and, after carefully studying Mr. Slott’s books, I am convinced that my dad should convert his TIAA/CREF fund to a ROTH when he retires next year. He doesn’t know much about IRAs, and he is worried about paying the conversion fee up front. Can the experts here confirm that I’m on the right track, or let me know if I’m off base?
Facts:
Dad is 71, will retire in 1-2 years.
Mom is 69.
Currently receiving ~$48,000 in Social Security payments.
TIAA/CREFF assets total $1.6 million
Outside assets, including primary residence, total approximately $3.5 million. No debt.
Two heirs, besides spouse: me and my brother, 36 and 39 years old.
Retirement goals: retain a $1.2MM home, with no mortgage, and spend approximately $150,000 a year including property expenses (taxes, insurance, maintenance).
My dad is worried that if he pays approximately $500k in taxes to convert the retirement fund, the remaining assets won’t be enough to live on for long enough to have the conversion make sense. I say that the IRA is the last asset he should use, and that he should convert the ROTH, drawing down outside assets to $3MM, and that this should be plenty to last long enough to make the conversion worthwhile, even if he and my mom run out of money and he has to start tapping the ROTH himself. If they have remaining ROTH assets when they pass away, that would be a bonus for me and my brother.
Am I thinking straight? The one argument that I’m trying to wrap my head around is my dad’s statement that large distributions from a non-roth IRA in the future could likely be largely tax free, since medical expenses are deductible from income, the medical expenses are likely to be large late in life, and so by keeping the conversion funds intact, and withdrawing only RMDs until he has medical expenses, he will likely come out ahead of the ROTH if for example long term care is required.
Any thoughts from the gurus here would be greatly appreciated!
Permalink Submitted by Bruce Steiner on Wed, 2011-04-27 14:06
There is a tradeoff between converting all at once (which gets more money into the Roth sooner, but bunches the income into a higher bracket in the year of conversion) and spreading the conversion out over a number of years. You might want to run a spreadsheet comparing these alternatives, making some reasonable assumptions as to investment returns and tax rates.
Nevertheless, if he doesn’t convert at all, he won’t be the first taxpayer to favor the IRS over his children.
Permalink Submitted by Peter Lingane on Wed, 2011-04-27 17:38
There is no easy answer.
If your parents were my customers, I’d suggest that we use tax software and current tax rates to estimate your parents’ income tax liabilities if they convert $1.6 MM in the year after retirement or if they do not convert. I suspect that the difference in federal tax will about 33% of the $1.6MM converted. The difference would be more if there is state tax.
Next, we would estimate the tax on required IRA distributions. I suspect that federal tax will be about 25% of the RMD in the immediate future, about 30% for several years thereafter and higher still if your parents live a long time or if the IRA is liquidated at the second death. If income tax rates increase or if Medicare premium surcharges apply absent conversion, the tax will be more.
Tax rates in individual future years need to be discounted to the year of conversion.
I’d not worry too much about the possibility of high medical expenses. About the only thing which triggers high medical expenses is dementia – nearly everything else is covered by Medicare. Your parents may have long term care insurance. In any event, they are unlikely to meet this need by distributing the IRA.
Your dad is probably looking at paying 3-8% more tax if he converts now than if the IRA is distributed gradually over his lifetime and, possibly, the lives of you and your brother. He will pay less extra tax if he converts over two years or if income tax rates increase or if there are Medicare premium surcharges absent conversion or if there is estate tax at the second death. The extra tax will be more if tax reform, of the type proposed by the President’s deficit reduction panel and by the Republicans, leads to lower tax rates in the future.
There will be no taxes on the future earnings on the money used to pay the liability now. Depending on how this money would have been invested, the tax saved by conversion could be substantial or relatively modest. There could also be tax saved because the RMD rules do not currently apply to Roth IRAs but this benefit would disappear if Congress repeals the Roth exemption from the RMD rules or if Congress repeals the rule allowing you and your brother to stretch-out an inherited IRA over your lifetimes.
Compare the extra tax paid if the IRA is converted to the extra tax paid if there is no conversion. The net is probably beneficial but the benefit may be less than you had thought. There is considerable uncertainty in whatever benefit you calculate because of the political risks mentioned and because the investment return might substantially exceed, or underperform, historical norms.
Consider alternatives to conversion. If your parents are charitably inclined, they can avoid tax on the IRA by donating it to charity during life or at death. There will be more after-tax wealth at the second death if the investment return were increased by a fraction of a percent. The returns of many portfolios can be improved by so modest an amount by rooting out unnecessary expenses and by paying attention to asset allocation and rebalancing. Would the family be ahead financially if your parents gifted you and your brother enough to pay off your student loans or home mortgages or to increase your own pension savings?
It’s probably worthwhile working though this exercise for your own satisfaction. But the financial case is probably not so compelling as to warrant pressuring your parents into something they do not understand.
Permalink Submitted by Bruce Steiner on Wed, 2011-04-27 18:33
On a $1.6 million IRA, the benefits of the conversion are sufficient to warrant a fair amount of effort. I would hope that it would be possible to explain, or for their lawyer to explain, the benefits of the conversion without having to pressure them into taking advantage of it.
Permalink Submitted by Benjamin O. on Wed, 2011-04-27 23:49
Thanks so much for your thoughtful replies. I guess a follow up question would be, what do you feel is the consensus thinking on the probability that the ROTH rules (deferral allowed, all withdrawals tax free) would not only be changed but also NOT grandfathered for existing ROTH holders? It just seems like there would be a lot of screaming from folks who made expensive decisions based on future guarantees, no?
Permalink Submitted by Alan Spross on Thu, 2011-04-28 01:24
There is hardly any chance that existing Roth balances would not be grandfathered in the event of restrictions for new Roth contributions. The removal of income limits for conversions and the two year deferral to encourage 2010 conversions would add extra “bait” to any bait and switch accusations in the event of law changes. There would be a huge amount of rage should that happen.
I think the largest threat here is probably the adoption of a VAT, which would replace other income tax rate increases and water down the value of Roth contributions and conversions and result in higher costs that could cause Roth assets to be distributed to pay for these costs. But for someone that converts only a share of their TIRAs, eg 25%, a VAT could hold back higher income tax rates on the 75% remaining in the TIRA at the same time that Roth contributions would be of less value. The real losers here would be those that converted a large share of their pre tax holdings.
Other possible restrictions might be treating Roth distributions like muni bond interest, ie they would not be directly taxed, but they would result in higher taxes on SS income by increasing AGI from that source. They could also make distributions subject to Medicare taxes for higher incomes in the fashion of the Obamacare tax on investment income starting in 2013.
But the threat of higher marginal income tax rates is far greater than any of these possibilities, so I would not keep all of my retirement assets in pre tax form. Tax diversification is still the best approach.
Permalink Submitted by Bruce Steiner on Thu, 2011-04-28 02:21
If the income tax rate on the conversion is less than, the same as, or not “too much” higher than the income tax rate that would otherwise apply when the IRA benefits are distributed, the conversion will be beneficial. If the income tax rate on the conversion is substantially higher than the income tax rate that would otherwise apply, then (or to that extent) the conversion will not be beneficial.
It may be a very long time until the last dollar of IRA benefits is distributed to the beneficiaries, especially if he or his wife lives long enough to see that his children have done well, so that he or she can leave some or all of the benefits to grandchildren. There is no way to predict future tax rates over that many years. It’s possible that tax rates will be much lower in the future than they are now. That would cut against converting. But it’s also possible that future tax rates will be higher than, the same as, or only slightly lower than they are now. That would cut in favor of converting. I wouldn’t make a large bet that future tax rates would be substantially lower than they are now, but others might.
There are other benefits to converting. There are no required distributions from a Roth IRA during lifetime. That can be a substantial benefit, especially if one spouse lives another 15 or 20 years.
Given the amount involved, it’s worth spending a couple of hours setting up a spreadsheet to compare the choices, making some reasonable assumptions. You might compare 3 choices — converting all at once, converting over a number of years, and not converting at all. You could even vary your assumption as to future tax rates to see how that affects the results.
But since he’s not yet comfortable with the conversion, you may be more successful if you can get him to convert a portion of his IRA this year.