Roth IRA conversions: What are you waiting for?

By John K. McGill, JD, CPA, MBA, and Brett S. Miller, CPA, CFP®

Starting in 2010, Congress removed the adjusted gross income threshold to convert an IRA to a Roth IRA, creating a terrific opportunity for high-income doctors to obtain the elusive benefits of a Roth IRA. Many doctors jumped at this opportunity, yet others remained idle. During a recent webinar on advanced Roth IRA conversion strategies, we were shocked to learn that less than half of the doctors polled took advantage of converting an IRA to a Roth IRA. The question we ask is, "What are you waiting for?"

What's so great about a Roth IRA?

A Roth IRA offers the holy grail of income tax-planning, tax-free growth! As a result, doctors must pay attention to the special benefits associated with a Roth IRA. While contributions and conversions to a Roth IRA are subject to income tax, all subsequent earnings grow and compound tax free. At retirement, distributions remain tax free, as long as the taxpayer is over the age of 59½ and has met the required five-year holding period.

Still not convinced? In addition to tax-free growth, two more important benefits are often overlooked. First, Roth IRAs are not subject to required minimum distributions. Unlike traditional IRAs, Roth IRA owners are not required to take distributions based on their life expectancy beginning at age 70½. Instead, Roth IRAs can remain fully invested and continue to grow until needed. Second, Roth IRAs present an excellent estate planning opportunity. Roth IRAs should be the last assets drawn upon in retirement, thus preserving the maximum balance to pass to beneficiaries. While the value of the Roth IRA will be included in the taxpayer's estate, the beneficiaries will continue to enjoy tax-free growth and distributions over their lifetimes. In essence, a Roth IRA enables doctors to generate two generations of tax-free growth.

Conversion strategy update

We previously outlined our IRA to Roth IRA conversion strategies in the January 2010 issue of Dental Economics (Have you converted yet?) and the May 2011 issue (How much can a Roth conversion save you?). In spite of recent tax legislation, the recommended conversion strategy remains consistent. Doctors should only convert after-tax IRA contributions to Roth IRAs on a tax-free basis, unless an opportunity comes along to convert pretax IRA money and pay taxes at a lower tax rate than their projected tax rate in retirement.

In addition to the original strategies, a new conversion opportunity came into effect as a result of the American Taxpayer Relief Act of 2012. With this last-minute legislation, Congress now allows qualified retirement plan participants to convert a portion of their pretax retirement assets to Roth assets. This occurs as an internal conversion, and the doctor will owe taxes for the conversion while keeping the converted Roth assets inside the qualified retirement plan. While this strategy is not a common recommendation due to the tax implications, it does present a new opportunity for doctors in a low-income-tax bracket. Events such as a natural disaster, health condition, accelerated depreciation, etc., may present a situation where a doctor's taxable income can temporarily be reduced to the 10% or 15% federal tax bracket for a single tax year. If this situation occurs, doctors should consider converting a portion of their qualified retirement plans to Roth assets up to the top of the 15% tax bracket.

Our goal

Regardless of the method used, the goal for every doctor and spouse should be to accumulate over $1 million in their Roth IRA by age 70 at the lowest possible tax cost. To achieve this, each spouse should begin to fund nondeductible IRAs and convert them to a Roth IRA tax free each year until retirement. The year after the practice is sold, doctors should convert taxable IRAs to Roth IRAs each year until age 70 (assuming they are in a very low tax bracket).

As an example, assume a doctor and spouse begin funding nondeductible IRAs and converting them tax free to a Roth IRA from ages 45 to 65. Once the doctor sells the practice, they will convert $50,000 from their taxable IRA to a Roth IRA each year from ages 66 to 70. As a result, the couple will make aggregate contributions and conversions of $463,000. Assuming an 8% annual rate of return, they will generate over $684,000 in tax-free growth. The net result is a Roth IRA balance of $1,147,000 at age 70! Several doctors are well on their way to making this example a reality. Are you one of them?

John McGill provides tax and business planning and publishes The McGill Advisory through John K. McGill & Company, Inc. Brett Miller provides investment advice through Select Consulting, Inc. (RIA). Both firms are affiliates of the McGill & Hill Group, LLC, a one-stop resource providing tax and business planning, transition, legal, retirement planning, CPA, and investment management services for dental professionals. Visit www.mcgillhillgroup.com.