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Beyond The Numbers November – December 2009

 

2010 Roth IRA Conversions - Plan Now

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Prior to 2010, only individuals with modified adjusted gross income (AGI) of $100,000 or less were entitled to convert amounts in their Traditional IRA (which includes funds that have been rolled over from a qualified plan) to a Roth IRA. If the filing status "married filing separate" was used, conversion was also prohibited. Beginning in 2010 however, the $100,000 modified AGI limitation on conversions of Traditional IRAs to Roth IRAs is eliminated completely. This favorable change in tax law gives everyone, regardless of income level or filing status, the opportunity to convert a Traditional IRA to a Roth IRA.

Why Convert to a Roth IRA?

Several important advantages are as follows:

  • Roth IRAs are not subject to the required minimum distribution (RMD) rules that apply to Traditional IRAs; there is no requirement for minimum distributions to begin when you reach age 70 1/2. Therefore, you can keep your money in a Roth IRA for a longer period of time and hence extend the period of tax-free growth.
  • To encourage Roth IRA conversions, Congress provided a special tax incentive, effective in 2010. The income generated as a result of a Roth conversion during 2010 will be taxed in that year and at the tax rates in effect. Or, an election can be made to spread the income equally over the following two tax years, 2011 and 2012, but the tax rates in effect for those respective years must be used. If Congress were to adopt pre-2001 rates after 2010, top tax brackets would rise noticeably, and many States are increasing their individual tax rates as well. Converting to a Roth IRA and paying the tax on the income in 2010 would in effect allow you to lock in 2010 tax rates and avoid potentially higher taxes in 2011 and 2012.
  • The Roth IRA can provide an effective estate planning opportunity whereby you can pass on your Roth IRA to your heirs, who can generally enjoy tax-free distributions throughout their lives. And, if you pass away holding a Traditional IRA, the entire amount may be included in your estate and taxed for both estate and income taxes. In the case of a Roth IRA, however, you have already paid the income tax and therefore your estate is smaller. While beneficiaries of Roth IRA accounts have to follow the same rules related to required minimum distributions ("RMD’s") as with a Traditional IRA account, the inherited Roth IRA account can often stay open many years, which can be very favorable.
  • IRA accounts have seen significant market value declines over the last year, making the tax cost of conversion much less than it would have been when the markets were at their peaks. As markets recover over time and growth resumes, that growth will be within the Roth IRA and potentially tax free if the qualifying tests are met for withdrawals from such accounts.
Factors to take into Consideration Before Converting to a Roth IRA:
  • Can you afford to pay the taxes on the converted amounts?
    When you convert your Traditional IRA to a Roth IRA, you will pay tax on all earnings and pre-tax contributions. Paying tax now will be in lieu of paying taxes upon later withdrawals from the Roth account. We advise that you do not tap into your IRA account to pay the conversion tax. By using other funds to pay the tax, you multiply the benefits of tax free compounding and if you are younger than age 59 1/2, a 10% early withdrawal penalty will generally apply.
  • Will the rollover disqualify you for important tax benefits?
    The conversion income could push you into a higher tax bracket. If that is the case, you may not qualify for benefits such as the college tuition tax credit and the dependent child tax credit. This income could also cause certain unfavorable consequences for deductions and other limitations that are linked to adjusted gross income.
  • How much time do you have until retirement?
    Due to our current economic slowdown, many individuals are contemplating postponing retirement. Although Roth IRAs have no age limitation on contributions or on mandatory distributions, generally, the older you are, the less sense it makes to convert your Traditional IRA to a Roth IRA. This is because there is generally less time to make up what you paid in taxes on the conversion.
  • Can I withdraw funds from the Roth IRA after conversion?
    Yes, but if a distribution is made from the Roth IRA following conversion, a 10% early distribution penalty applies if the withdrawal occurs within 5 years after you convert.
  • Are Other Qualified Plan Accounts Eligible for Conversion?
    Yes, accounts including 401(k), 403(b), and 457 plans are eligible. However, distributions from such accounts generally are not allowed until there is a retirement or a separation of service. Conversions of these types of accounts may be limited by the controlling terms of the plan.
  • Can I convert my Traditional IRA if I am already receiving required minimum distributions ("RMDs")?
    Yes, if otherwise qualified. However, required minimum distributions are not eligible for conversion.
Is Re-characterization Possible?

Yes. An important factor to consider as part of any conversion strategy is the ability to undo the conversion and transfer the converted Roth IRA funds back to the Traditional IRA account. The tax law provides that such a conversion back to a Traditional IRA can be made no later than the due date of the income tax return for the year, including extensions. For example, a taxpayer could convert from a Traditional IRA to a Roth IRA in early 2010, and have up to October 15, 2011 to re-characterize the Roth IRA back to a Traditional IRA account. If the assets in the Roth increased in value, an ideally situated taxpayer would leave the funds in the Roth IRA and pay the conversion tax in either 2010 or over the two year election period. In this situation, you would be paying the conversion tax in order to have a higher value in the Roth account for future potentially tax-free distributions.

However, if the investments, post-conversion, decrease in value and the decision is made to re-characterize the Roth IRA back to a Traditional IRA account within the time periods allowed, there would be no recognized income on either transaction, and you would be back in the same position as though no conversion transaction had occurred.

What Should You Be Doing Now?

Consider setting up different asset classes within your Traditional IRA accounts now, prior to converting to a Roth in 2010. Then, convert each Traditional IRA account into a separate Roth IRA account in early 2010. This allows for the possibility of paying the conversion tax on the account classes that have increased in value, while re-characterizing back the accounts that have decreased in value.

If you qualify, consider using a multi-year strategy for conversion. For 2009, if you do not expect to exceed the $100,000 modified adjusted gross income level that prohibits a conversion, consider converting some of your Traditional IRA account to a Roth IRA account this year.

Set aside funds that may be necessary to pay the tax on the income resulting from the conversion.

You can achieve the maximum benefits of a Roth IRA Conversion if planning is done early in 2010. If you have any questions about how the Roth IRA Conversion rules may affect you, please contact your Marcum tax professional.
 
 
 
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