|Roth IRA Conversion
Should you take advantage of the new opportunity to convert your traditional IRAs to Roth IRAs?
Mark Holzgang, CPA, Principal | Bogumil, Holzgang & Harris, P.C.
We have been asked this question daily since the guidelines for converting traditional IRAs to Roth IRAs were relaxed. The answer to this question is very specific to each individual's situation. Following is an overview of this opportunity,an opportunity that our firm believes should at east be considered by anyone possessing a traditional IRA.
The Roth IRA was first introduced in 1997 to allow individuals to contribute to an IRA with after-tax dollars. The benefit comes at the time of retirement when qualified distributions can be taken from the Roth tax free. Herein lies the main tax benefit of the Roth IRA – tax free investment earnings. However, there are income limitations for being eligible to contribute to a Roth IRA. Single taxpayers cannot contribute if their Adjusted Gross Income (AGI) is over $120,000 (2009 Limit), and on joint tax returns the limit is $176,000 (2009).
In addition to making Roth contributions, you are also allowed to convert a traditional IRA to a Roth IRA if you claim the income attributable to the traditional IRA. In the past, taxpayers could not convert if the AGI on the tax return, excluding the conversion amount, was over $100,000. The guidelines pertaining to this conversion were relaxed in 2010.
In the early 2000s, President Bush proposed reductions in tax rates. At the time, there was a political rule that was known as "Pay-Go". This rule provided that any legislation that reduced revenues or increased appropriations would need to be paid for within the bill. In other words, it needed to be revenue-neutral. The means by which Congress chose to pay for the reduced tax rates was to remove the income limitations in 2010 and thereafter pertaining to IRA conversions, hence this new opportunity for you to consider.
The Mechanics of Converting to a Roth IRA
To convert your traditional IRA to a Roth IRA using the same investment adviser or custodian, simply indicate your desire to do so and a new Roth account will be set up to accept the investment from your current IRA. If you desire to change investment advisers, indicate to your current adviser that you wish to convert and move to another investment adviser. They can either liquidate your current holdings and transfer cash, or an in-kind distribution can be made and your current investments can be transferred. This is known as a trustee-to-trustee direct transfer.
In our modeling and in the opinion of most advisors, the best advantage is obtained by using non-retirement funds for paying the income taxes on the conversion. The taxes may be paid right away or they can be deferred to the next two tax years.
Another key provision that has been widely misunderstood is the calculation of the taxable portion of the conversion. Suppose you have two IRAs, one a fully taxable rollover of $200,000 from a previous employer and the other an IRA worth $50,000 to which you have contributed $25,000 of non-deductible contributions. Your wish is to convert the $50,000 which has $25,000 of after tax money (tax basis); therefore, there is only $25,000 of taxable income, right? Not so fast. The Internal Revenue Service considers all of your IRAs as if they were one. The tax basis in your IRA ($25,000) is spread ratably over your combined IRA values ($250,000). In this case, any conversion will be 10% (25,000/250,000) tax-free return of basis and 90% taxable.
Benefits of Roth Conversion
As mentioned earlier, the main benefit of converting is that investment earnings will never be taxed if withdrawals are qualified withdrawals. Qualified withdrawals are defined as distributions made after age 59½ and after a 5-year waiting period for each conversion. The waiting period begins on the first day of the year of conversion. Death and disability also would allow for qualified withdrawals.
Another benefit only for 2010 is that you can elect to delay the reporting of income from a 2010 conversion to 2011 and 2012. If you decide to make this election, you would claim 50% of the taxable conversion in both 2011 and 2012, subject to 2011 and 2012 tax rates. Care should be taken in making this election, as tax rates are already scheduled to increase in 2011 absent any further legislation.
For some of our clients who possess considerable retirement plans, the rules pertaining to Required Minimum Distributions (RMDs) at age 70½ can be burdensome at best. The advantage that a Roth has over other retirement assets is that it is not subject to RMDs. It can be very useful to have both taxable and non-taxable retirement assets since you are not required to take distributions from the Roth.
Currently Congress has repealed our estate tax law in 2010 and it is scheduled to return in 2011 with a lower exemption amount. A crystal ball would be nice for planning purposes, but in the meantime the Roth has some estate planning benefits that should be considered. If you pass away with taxable retirement accounts, they are fully valued as part of your estate. At some point in time your heirs will pay income tax on the distributions. If you convert all of your taxable retirement to a Roth IRA, you reduce the size of your estate by the income taxes paid on the conversion. If you know that you will have a taxable estate (normally in the 50% estate tax range) then isn't the government really paying for one half of the income taxes that you pay on conversion? This is definitely something to consider. Additionally, a Roth IRA is a much easier means of transferring wealth to the next generation.
Currently, the AGI limits for contributing to a Roth are still in place. However, there is no current law that disallows contributing to a traditional IRA (non-deductible) and immediately converting it to a Roth IRA. We expect that there will be future legislation either removing the AGI limits for Roth contributions or closing this obvious loophole.
In our modeling, converting is most advantageous when it is done at a point where you can leave the Roth investments to grow for 10-14 years, at which time the benefits will typically outweigh the taxes paid up front at conversion. Obviously, the higher the return on investment and the longer you have until you start drawing on the funds, the better the benefit.
The Planning Process
We recommend that you consult with your team of advisors including your CPA, your financial advisor and your estate planning attorney to help with the process of making an informed decision. There are several variables that come into play in the planning: investment rates of return, age, current tax brackets, tax brackets at retirement, retirement desires and retirement draw-down, to name a few.
Mitigation of Tax on Conversion
You may consider mitigating the income taxes resulting from the conversion by accelerating any planned giving to charities such as the DFO. If your philanthropic desire is to someday provide for a qualified charity, there are tax advantageous tools available that may offset some or all of the income taxes owed on a Roth conversion. Certainly, gifting of appreciated property such as real estate or securities (stock/mutual funds) has some very favorable tax treatment possibilities, as do certain charitable remainder trusts (CRUTS). Please consult with your tax advisor regarding use of these tools.