Roth IRAs: The Conversion Decision
On January 1, 2010, the income ceiling for Roth IRA conversions disappeared. Regardless of income or filing status, taxpayers may now convert traditional IRAs, SEP IRAs, SIMPLE IRAs or rollovers from a retirement plan to a Roth IRA.
If a taxpayer converts a traditional IRA into a Roth IRA in 2010, the income tax liability can be deferred until 2011 and 2012. The taxpayer has the option to claim 50% of the conversion amount as income in 2011 and the remainder in 2012. This special rule only applies to conversions that take place in 2010. If the taxpayer believes that his or her tax rates will be higher in 2011 and 2012, it may be more advantageous to pay the income taxes on the conversion in 2010, rather than take advantage of the deferral option.
Traditional vs. Roth
A Roth IRA is, in a way, the opposite of a traditional IRA. The Roth IRA is funded with after-tax dollars, while a traditional IRA is funded with pre-tax dollars. Distributions from a Roth IRA are tax-free (subject to a five-year holding requirement and attainment of age 59½, death or disability), while distributions from a traditional IRA are taxed at ordinary income tax rates. For a traditional IRA, the age 70½ minimum distribution rules apply.
Depending on the taxpayer's date of death, a large portion of the traditional IRA may be distributed during his or her life. Unlike a traditional IRA, a Roth IRA has no required minimum distributions during the taxpayer's lifetime. If the taxpayer does not need these funds, the Roth IRA can grow tax-free over the remainder of his or her life.
To Roth or Not: Factors to Consider
Future tax rates greatly affect the merits of a Roth IRA conversion. If a taxpayer believes that his or her tax rate will decline in the future (as a result of leaving the workforce or moving to a state with no income taxes), that taxpayer will actually accelerate taxes at a higher tax bracket by converting to a Roth IRA.
The source of funds used to pay the income tax liability also affects the conversion decision. If a taxpayer uses other assets, rather than IRA funds, to pay income taxes resulting from the conversion, more dollars are available for tax-free growth.
The time horizon for assets to grow unencumbered by taxes is another important factor. A longer time horizon exists if the taxpayer does not expect to spend IRA assets during retirement. Because Roth IRAs are exempt from required minimum distributions, they can grow tax-free for a longer period of time than a traditional IRA.
For taxpayers who are subject to the estate tax, a Roth IRA conversion can lower the estate tax liability if the income tax on the conversion is paid with funds outside of the IRA. However, an income tax deduction does exist for IRA beneficiaries when the decedent owned a traditional IRA and federal estate taxes were paid after his or her death. This deduction may nullify the estate tax benefit of a Roth conversion. Ultimately, what matters is not the estate taxes themselves but the amount the family has left after estate taxes have been paid.
The income tax cost of a Roth conversion may be reduced if the taxpayer has net operating losses or charitable deduction carryforwards. Capital loss carryforwards cannot be used to offset income from a Roth conversion.
Maximize Conversion Benefits with Re-Characterizations
A taxpayer can change his or her mind after a conversion and re-characterize the Roth IRA back to a traditional IRA. The re-characterization must be made before the due date of the tax return (including extensions) for the year of conversion. If the taxpayer re-characterizes back to a traditional IRA, he or she must wait 30 days after the re-characterization to make another conversion to a Roth IRA (and the re-characterization cannot take place in the same taxable year as the first conversion).
For example, if Sam the taxpayer converts his traditional IRA worth $1 million on January 1, 2010, and the value of the Roth IRA has decreased to $800,000 on December 1, 2010, then he should re-characterize back to a traditional IRA. On January 1, 2011, Sam can again convert his traditional IRA into a Roth IRA. By doing so, he will reduce his income tax liability by $70,000 (based on a 35% bracket and assuming the IRA has a value of $800,000 on January 1, 2011).
Although more complicated, a much more beneficial conversion method involves splitting the traditional IRA into multiple accounts. Under this scenario, each IRA is converted to a Roth IRA but invested differently. Towards the end of 2010, the taxpayer reviews his or her accounts and can decide to re-characterize some or all of the Roth IRAs back into traditional IRAs.
For example, let's say Sam the taxpayer splits his traditional IRA into four IRAs, each worth $250,000. He then converts all four into Roth IRAs, each with a different investment strategy. Sam's potential tax liability for the conversions is $350,000. On December 1, 2010, two of the four Roth IRAs have decreased in value to $150,000 and $200,000. Sam then re-characterizes the two Roth IRAs that have declined in value back to traditional IRAs. On January 1, 2011, Sam again converts these two traditional IRAs into Roth IRAs. Even though the total value of the IRAs did not change, this re-characterization technique has allowed Sam to reduce his overall income tax liability by $52,500 (assuming a 35% bracket).
The Nondeductible IRA Option
Joint filers with modified adjusted gross income in excess of $176,000 (for 2009) cannot make contributions to Roth IRAs. However, this category of taxpayer (if under age 70½) may still make an annual $5,000 nondeductible IRA contribution ($6,000 if age 50 but less than age 70½). If married, an annual nondeductible IRA contribution can also be made for the taxpayer's spouse, regardless of whether the spouse has earned income. So long as the taxpayer and spouse do not maintain any other IRAs, these nondeductible IRA contributions can be converted annually to a Roth IRA at no tax cost. All taxpayers who are not eligible to make a Roth IRA contribution and who do not have other IRAs should consider this conversion. If a taxpayer already has a traditional IRA and opens a new account for the nondeductible contribution, the IRAs are combined for purposes of determining the taxable amount of the distribution. The excludable amount is the ratio of the total nondeductible contributions divided by the sum of all the taxpayer's IRA balances.
Clearly, Roth IRAs now offer a variety of advantages to taxpayers of every income and filing status. Whether you can expect a worthwhile tax benefit, however, depends on your particular circumstances. If you have questions or would like assistance evaluating the Roth IRA conversion as part of your overall tax strategy, please your attorney.