June 3, 2010

Tax Free Roth IRA Conversion – A Possibility

Tax Free Roth IRA Conversion – A Possibility

Undoubtedly, you have read and heard in the media and financial press about the unique Roth IRA conversion opportunities which have come into existence in 2010. The opportunity exists because there is no longer an income threshold (formerly modified adjusted gross income of $120,000 for single filers and $176,000 for joint filers) above which conversion is prohibited. However, conversion generally comes with a tax cost equivalent to the tax you would pay on wages, which in most cases is fairly substantial. As a result, once the economics are considered, in many cases it does not make economic sense to accelerate the payment of tax in order to enjoy the benefits of having a Roth IRA, which includes tax free earnings, tax free distributions, and the avoidance of required minimum distributions -meaning the requirement for the initial Roth IRA owner and spouse to take minimum distributions at age 70 ½ is eliminated. Additionally, Roth IRAs inherited by a nonspouse, such as a grandchild, would require distributions but would be able to be ‘stretched’ providing for substantially continued benefits with savvy estate planning.

Having discussed why in many cases a Roth IRA conversion may not be a prudent economic decision, what follows is an opportunity you might place in the “too good to be true” category. In particular, IRA contributions over the years have fallen into two categories:

  1. deductible contributions made with pretax dollars and limited to those with taxable income under stipulated levels and
  2. nondeductible IRA contributions made with after tax dollars.

The nondeductible IRA contributions were typically made by high net worth individuals who most likely also participated in a Workplace Retirement Plan (“WRP”) and whose income exceeded the limit for deductible IRA contributions. Reasons for making nondeductible IRA contributions include the future non taxability of

  1. subsequent interest,
  2. dividends or
  3. capital appreciation,(collectively the “growth”), until distribution, and that tax deferral was enough of a benefit to encourage participation.

Generally, Form 8606 was included with the annual federal income tax return which tracked the cumulative contributions to the nondeductible IRA. Having this form or developing a similar record of nondeductible IRA contributions will provide the answer to how much you can convert to a Roth IRA without the payment of any income tax.

The Roth conversion rules prohibit selecting only after tax contributions for the conversion in the event your IRA accounts contain pre- and post- tax contributions and growth. As a result, in a conversion, if, for example,pretax contributions and growth aggregated $150,000 and after tax contributions were $100,000, the $250,000 Roth IRA conversion would be taxable to the extent of 60% or $150,000; that is, the $100,000 after tax contribution – the basis amount – would not be taxable, but all other amounts in the conversion would be taxable. Further, in any conversion, you must aggregate all accounts together for purposes of this computation so, even if you look to a specific IRA account with only basis from after tax contributions, upon conversion a portion of that account would be taxable if you had other accounts that included pretax contributions and growth.

Here lies the unique opportunity. Most WRPs, such as a 401(k) Plan, allow employees to rollover IRA contributions into the WRP. Such as rollover provides the ability to reduce the amount in your IRA account(s) by rolling any amount in excess of your cumulative after tax contributions or basis into the WRP so that when accomplished the only amount left in your IRA is the basis or after tax contributions. Upon conversion of this amount (the basis or after tax contributions) to a Roth IRA, there would be absolutely no federal income tax, upon conversion. In addition, there would be no federal income tax or 10% early distribution penalty in future years, upon distribution, as long as the individual was over 59½ at the time of conversion or does not take any distributions for five years and is over 59½ at that time

In summary, if you have ever made after tax contributions to an IRA and you currently participate in a 401(k) plan or WRP where your employer allows the rollover of IRA funds, your situation would allow you to convert your after tax IRA contributions to a Roth completely free of federal income tax (after having rolled any growth and pretax contributions into your WRP). The economics of such a conversion are, without a doubt, compelling, and anyone in this situation should consider this unique opportunity.

For more information, please contact your dedicated Marcum LLP professional.