Over the last two years, there has been a lot of discussion about converting traditional IRA funds to Roth IRA funds.  Also, many taxpayers are unable to make Roth IRA contributions due to the IRS income limitations.  Roth IRAs can help diversify against the risk of increased future tax rates.  Let’s look at strategy to help accomplish the goal of increasing Roth IRA balances.

Most investors understand the idea of diversification of their investments.   Assets should be invested in multiple classes of equities, fixed income, real estate, and alternative investments to spread the risks.  It is also important to understand the concept of tax diversification. The tax diversification triangle below shows how investments are subject to tax in three different ways.  Some investment income is taxed immediately. Assets in non-qualified accounts like regular brokerage accounts or CDs are taxed as the income is received.  The income from tax deferred accounts such as IRAs, annuities and qualified employer retirement plans is taxed when withdrawn from the account.  The third group is income that is never taxed and includes municipal bonds and Roth IRAs.

Roth IRAs offer the ability to invest in a portfolio of investments that can be diversified to reduce investment risk and also to protect against tax rate risk.  If we look at the three ways investment income is taxed as buckets, our goal should be to attempt to equalize the assets in each of the buckets to provide for the greatest flexibility in planning distributions during retirement.  Many individuals are over-weighted in the tax deferred bucket as a result of employer provided retirement accounts.  These assets grow tax deferred but will be subject to tax when withdrawn at the income tax rate in effect in the year of distribution.  The theory that an individual will be in a lower income tax rate in the future does not always hold true.

With the removal of the income limitation on the conversion of traditional IRA accounts to Roth IRA accounts, some taxpayers were able to convert large balances to the tax free Roth IRA bucket.  However, some people do not have the cash available to pay the tax due as a result of the conversion of their traditional IRA accounts to the Roth.  They may also be unable to fill the tax free Roth bucket with current Roth IRA contributions because they exceed the income limits placed on Roth IRA contributions.  The strategy presented here will help you to fill the tax free bucket over time and work around the income limitations for Roth IRA contributions.

If you have a traditional IRA account, we know the value is less than advertised due to the unpaid future tax.  If you are in a 30% federal and state income tax bracket a $40,000 IRA is worth $28,000 after paying $12,000 (30%) in tax.  A married filing jointly couple over the age of 50 can each make a $6,000 IRA contribution for a total of $12,000.  If their combined Adjusted Gross Income (AGI) is less than $169,000 in 2011, they can make the full contribution to a Roth IRA.  If the couple has the $12,000 available and has a goal of increasing the tax free bucket of their investments it may be best to convert $40,000 of a traditional IRA to a Roth IRA and use the $12,000 to pay the resulting tax.  This allows taxpayers over the AGI threshold to create a Roth IRA and can help any taxpayer diversify the taxability of their investment portfolio.

Let’s compare two scenarios.  If the above taxpayers make Roth IRA contributions totaling $12,000, they will have a traditional IRA account of $40,000 worth $28,000 after tax and Roth IRA accounts worth $12,000, for a total after tax value of $40,000.  If they convert the $40,000 traditional IRA to a Roth IRA and use the $12,000 to pay the resulting tax, they end up with a $40,000 Roth IRA account with an after tax value of $40,000.  But what have they gained?  The Roth IRA account will grow tax free.  They have diversified a portion of their retirement savings to the tax free bucket which will allow for more flexibility and planning during the distribution phase of their retirement.

Roth IRA accounts are not subject to the Required Minimum Distribution (RMD) rules.  Therefore future RMD amounts will be reduced.  In an unstable tax rate environment diversification among all three of the tax buckets will allow the taxpayer to have greater control over when and how much of their retirement savings will be subject to tax and at what rate.

Contributions to a Roth IRA can be made up to April 15 following the tax year.  Roth IRA conversions must be completed by December 31 of the year of conversion.  By sitting down and planning a strategy to convert IRA balances over time, you can improve the tax diversification of your investments.  We can  demonstrate the benefits of this diversification during the distribution phase of your retirement.  Contact your tax advisor to set up an appointment.