Is a Roth IRA Conversion for You?
Congress devised the Roth IRA in 1998, creating a novel option for taxpayers to pay tax currently in order to exempt some assets from the income tax system down the road. But Congress created a Catch 22 situation by setting income limitations on who qualified for the Roth opportunity. If you could afford “to Roth,” you generally weren’t eligible; and if you were eligible, it was generally difficult to afford to take advantage of the opportunity.
Beginning in 2010, however, the rules change such that anyone with a traditional IRA is eligible to convert any or all of it to a Roth IRA. Anyone who is willing to pay income taxes currently on those assets converted to a Roth IRA can now have an investment account that remains outside of the income tax system for at least a generation.
While we expect many clients will find this new opportunity compelling, it won’t be a “no brainer” for everyone. Consequently, we plan to work with each of our clients early in 2010 to explain the opportunity and thoroughly evaluate whether and how much of their existing traditional IRA assets to convert to a Roth.
In the interim, we present here some of the nuts and bolts of the tax rules, and considerations for conversion opportunities.
Roth IRA v. IRA – The Basics
Operationally, a Roth Individual Retirement Account (“IRA”) is much like a traditional IRA. Both are available to individuals who receive taxable compensation (i.e. salary, wages, commissions, self-employment income) and the rules regarding the timing and amounts of contributions are similar. Early distributions (before age 59 ½) from either account are subject to both ordinary income tax and an additional 10% penalty tax.
|IRA (including Roth IRA) Contribution Limits
||Age 49 & Below
||Age 50 & Above
However, there are significant differences in the income tax breaks offered to the owners of these accounts.
Contributions to traditional IRA accounts may or may not be deductible depending on whether the owner or spouse participates in an employer’s qualified retirement plan, and subject to income limitations. Nondeductible contributions may be made regardless of income level. At age 70 ½, traditional IRA owners can no longer make contributions and are required to begin withdrawing minimum amounts determined by the value of all traditional IRAs held and IRS life expectancy factors. Account earnings are untaxed until distributions are made, at which time the deductible portion of contributions and 100% of earnings are taxed as ordinary income.
Roth IRA contributions can be made regardless of age. However, they are never deductible and cannot be made if the owner’s or spouse’s income exceeds certain limits (although after 2009, the income limitations for IRA conversions no longer apply). Distributions are non-taxable, provided the funds have been in the account for at least five years and the owner is at least age 59 ½. Roth IRAs can be especially effective in passing wealth to future generations because the minimum distribution rules that apply to traditional IRAs do not apply to Roth IRAs (resulting in longer tax-free compounding) and the eventual distributions to account beneficiaries after the owner’s death are non-taxable.
Converting Traditional IRAs into Roth IRAs
Until now, an individual with adjusted gross income (subject to some modifications) in excess of $100,000 and married taxpayers who file separate returns have not been eligible to convert assets from traditional IRAs into Roth IRAs. However both the income and filing status restrictions are eliminated after 2009.
The two principal objectives of converting a traditional IRA into a Roth IRA are to avoid income tax on the IRA earnings that accrue after the conversion and to avoid having to make required minimum distributions after reaching age 70 ½.
In consideration of the available tax benefits, the best candidates for conversions will generally be those persons who:
- will not need to distribute the converted assets for at least five years
- have sufficient non-IRA assets from which to pay the conversion tax
- do not expect a significant decline in their effective tax rate in retirement, and
- do not plan to donate the IRA to charity.
Tax Consequences of Conversions
Taxpayers who convert assets from a traditional to a Roth IRA will be taxed on the portion of the transfer that represents pre-tax (i.e. previously deducted) contributions and earnings. Conversions that occur in 2010 (only) will not be immediately recognized as taxable income. By default, the conversion income realized in 2010 will be recognized in two equal installments on the owner’s 2011 and 2012 federal income tax returns. Alternatively, a taxpayer may elect to report all of the income on his 2010 income tax return.
Conventional wisdom generally directs taxpayers to defer recognition of income. However, because tax rates are widely expected to increase from current levels after 2010, most clients who choose to convert an IRA in 2010 will benefit from waiving the special income recognition rule and instead recognize the conversion income in 2010.
The rules allow for conversion of any portion of the traditional IRA to the Roth. For clients whose IRAs represent a large portion of their portfolios, partial conversions will probably make the most sense.
Generous “2nd Look” Opportunity
If the value of converted assets decline, or a taxpayer decides to undo all or part of a conversion for any other reason, he can elect to reverse the conversion in a transaction the IRS calls a “recharacterization”. There is no income tax cost for a recharacterization and taxpayers have until the extended due date of the income tax return for the year the conversion occurred to make this election. Therefore, the final date to reverse 2010 conversions will be October 17, 2011. To maximize the benefit of this 2nd look opportunity, we will encourage clients to engage in the Roth analysis in the first half of 2010.
To simplify the analysis of the conversion and the execution of potential recharacterizations, we recommend depositing the assets from Roth IRA conversions into a new account rather than into an existing Roth account. After the deadline for recharacterizations has passed, the Roth accounts can be combined.
Recharacterized assets can again be converted into a Roth IRA after the later of:
- January 1 of the year after the original conversion or
- 30 days after the date of the recharacterization.
Other Tax Considerations
Traditional IRA owners who reach age 70 ½ prior to converting those assets into a Roth IRA will still be required to withdraw their required minimum distribution (“RMD”) for that year.
Estimated tax planning should include an analysis of whether income tax withholding and/or estimated tax payments should be adjusted to reflect the impact of a Roth IRA conversion.
Taxpayers are advised to check the laws of their resident state to determine whether, and to what extent, the post-2009 IRS tax provisions will apply to their state income returns. California, for example, has not yet conformed to any of the special post-2009 IRS provisions discussed previously. However, it is our expectation that most states will conform, at a minimum, to the elimination of the income threshold for Roth IRA conversions.
Aspiriant’s plan for clients
Since we expect most clients to benefit from at least a partial conversion of their traditional IRA to the Roth, we anticipate executing a large number of conversions. In order to keep the process manageable, we plan to talk with clients and execute conversions during the first quarter of 2010 (to maximize the “2nd look” opportunity). Assuming most clients will elect to recognize the income in 2010, estimated tax payments may be due for the quarter when the conversion occurs. If you have not already heard from your client service team with regard to your own situation, you can expect to hear from them sometime in the first quarter.
Ray Edwards, Kacy Gott, and Clay Stevens