How much can a Roth IRA conversion save you?

by John K. McGill, MBA, CPA, JD, and Brad Kucharo, CPA, CFP®

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Virtually every doctor and spouse can now enjoy the benefit of tax-free growth through a Roth IRA. While direct contributions to a Roth IRA are not permitted for high-income doctors, all doctors can now convert their regular IRAs into Roth IRAs, regardless of income level. This has created a virtual frenzy for Roth IRA conversions among doctors.

While estate planning advantages are important, it's the tremendous income tax savings that make Roth IRAs particularly attractive, says tax planning expert Brad Kucharo, CPA, CFP®. Distributions from Roth IRAs are tax-free if made after the age of 59½ and at least five years after opening the Roth IRA. Moreover, Roth IRA withdrawals are not subject to the new 3.8% Medicare (payroll) tax on personal investment income (i.e., income, dividends, interest, capital gains, etc.) received by high-income doctors, beginning in 2013.

For these reasons, Mr. Kucharo recommends that high-income doctors and spouses make the maximum regular, nondeductible IRA contributions annually of $5,000 per spouse per year, or $6,000 for each spouse age 50 or older.

Then the taxable portion of each spouse's IRA can be rolled over tax-free into the practice's retirement plan, leaving only the cumulative after-tax, nondeductible contribution amount. These amounts can then be converted tax-free into Roth IRAs. Thereafter, new nondeductible regular IRA contributions should be made for each spouse annually, and then immediately converted into Roth IRAs.

Mr. Kucharo also recommends that doctors convert additional portions of their taxable IRAs into Roths following the sale of their practice. During the years following the sale when the doctor is living off the after-tax sales proceeds, he or she will have little taxable income. This provides a tremendous opportunity to convert regular IRAs into Roth IRAs at extremely low tax rates.

During his recent "Planning for Retirement" seminar, Mr. Kucharo discussed one client who, upon his recommendation, converted $100,000 per year of taxable IRA proceeds into Roth IRAs each year following his practice from age 66 through 70.

Since a portion of this income was offset by the doctor's personal exemptions and itemized deductions, and most of the remainder was taxed at only the 10% and 15% rates, the total federal income taxes due on the IRA proceeds converted was less than $10,000 a year, or $50,000 total, on the $500,000 amount converted.

Accordingly, Mr. Kucharo said this doctor saved more than $125,000 in federal income taxes from undertaking this Roth IRA conversion when his effective tax rate was less than 10%, rather than converting the taxable portion during his higher earning years, when his maximum tax rate was 35%.

While the doctor was impressed by the reduction in taxes through conversion of his regular IRA into Roths in annual installments following his practice sale, he still wanted to know the amount of his future tax savings and how that compared to the tax costs incurred in converting. Mr. Kucharo assumed that the $500,000 inside the taxable IRA earned 6%, and would have been paid out in equal monthly installments over a span of 30 years. That would have resulted in payments of $2,997.75 per month, or $35,973 annually.

Based upon a projected federal income tax rate of 25% in retirement, the annual federal income taxes due on the IRA payout would be $8,993.26. Over the 30-year payout, the total income taxes paid would be $269,798. Subtracting the $49,900 in federal income taxes paid to convert to Roth IRA status resulted in a net tax savings of $219,898 by converting. Adjusting the future tax savings to their present value using a 6% discount rate still provided a net savings of more than $75,000 in today's dollars.

Many doctors may be in a higher tax bracket after age 70½, due to required retirement plan and taxable IRA payouts, which would increase the potential tax savings. Furthermore, if tax rates rise in the future as expected, the tax savings would be even greater, says Mr. Kucharo. Finally, if the doctor does not make withdrawals from the Roth IRA over his lifetime, but passes the Roth IRA to his children to continue the tax-free growth, the savings would be even greater.

John McGill and Brad Kucharo provide tax and business planning exclusively for the dental profession and also publish the popular newsletter "The McGill Advisory" through John K. McGill & Company, Inc., a member of The McGill & Hill Group, LLC. The McGill & Hill Group's members and affiliates collectively serve as a one-stop resource for tax and business planning, practice transition, legal, retirement plan administration, CPA, and investment advisory services. Visit www.mcgillhillgroup.com for more information.