Congress dangled an incentive for high-income Americans to convert their tax-deferred individual retirement accounts into post-tax plans. Their response was overwhelming.
Conversions from regular IRAs to Roth retirement accounts increased more than nine times in 2010, rising to $64.8 billion from $6.8 billion in 2009, according to data released yesterday by the Internal Revenue Service.
That marked the first time Roth conversions were greater than contributions. Conversions were especially common among IRA holders with annual incomes exceeding $1 million. More than 10 percent of them converted to a Roth account, the IRS said.
“It’s a terrible deal for the Treasury because the reason people do the conversion is they expect to save a lot more money than they’ll pay in taxes in the future,” said Leonard Burman, director of the Tax Policy Center in Washington. “The people for whom Roth IRA conversions are attractive are people who don’t need their IRAs for retirement.”
The increase in conversions stemmed from a 2006 law that set 2010 for ending a $100,000 income limit on Roth conversions. There’s no ceiling on conversions if an investor has multiple IRAs and no cap on the amount that can be shifted.
“There was a rush of interest in 2010,” when the restrictions on conversions were lifted, said Thomas Rowley, director of retirement business strategies for Atlanta-based Invesco Ltd. Wealthy investors could better manage their tax liability in retirement and pass the Roth accounts to heirs free of income tax, he said.
“It’s the cheapest estate planning you can find,” Rowley said. “You’re paying the taxes for these beneficiaries.”
Taxpayers also could split the taxes owed because of the conversions between their 2011 and 2012 returns, giving them until early 2013 before they had to pay the full balance. Wealth advisers pitched Roth conversions to their clients as a pay-now, save-later strategy.
Taxpayers with incomes exceeding $1 million made up 4 percent of the 869,400 Roth conversions in 2010; they moved $14.4 billion, or 22 percent of the money.
When Congress passed the law, the Joint Committee on Taxation estimated that it would raise $6.4 billion for the U.S. government over 10 years. Because Congress looks at the revenue effects only for the first decade, changes that make retirement tax breaks more generous in the long run can be used to offset tax cuts.
At the time, the Tax Policy Center estimated that the break would cost the government the net present value of $15 billion in revenue over the long run.
“It’s like going to the loan shark to finance your current consumption,” Burman said. “It’s billions and billions of dollars that the Treasury is basically giving away for no valid public purpose. It’s not increasing savings.”
Congress passed a similar law in 2013 allowing for easier conversions into Roth 401(k) accounts.
Both changes to Roth plan rules were a “classic budget timing gimmick,” said Ed Lorenzen, senior policy adviser at the Committee for a Responsible Federal Budget and a former House Democratic aide.
“You know by its very design it’s going to be raising revenues now and losing revenues later,” he said. “It’s usually done purely for the purposes of meeting budget rules to appear to be generating revenues.”
Contributions to a regular IRA are tax-deferred, with up-front deductions and taxes owed when the money is withdrawn from the account.
In contrast, Roth accounts are built with post-tax money. Account holders owe no taxes when they withdraw the money and don’t have to make withdrawals once they reach age 70 1/2.
Assets in individual retirement accounts, known as IRAs, totaled $6 trillion as of Sept. 30, according to the Investment Company Institute. Almost four out of 10 U.S. households owned IRAs in 2013, ICI data show.
About 16 percent of U.S. households, or 19 million, have Roth IRAs compared with about 36 million owners of regular IRAs in 2013, according to the ICI. Roth IRAs, named for former Senate Finance Committee Chairman William Roth of Delaware, were first available in 1998, the ICI said.