“Roth IRA Conversion: New Opportunity for Higher Income Taxpayers Beginning in 2010” by Jennifer K. Huckfeldt
Beginning in 2010, taxpayers are permitted to convert traditional IRAs to Roth IRAs without regard to their income level or filing status. Following is a brief summary of this opportunity:
Conversion Requirements. Prior to 2010, an individual with modified adjusted gross income exceeding $100,000, or with a filing status of married filing separately, was not permitted to convert a traditional IRA to a Roth IRA. These two requirements have been removed as of January 2010. Thus, for 2010 and future years, all taxpayers will be permitted to convert traditional IRAs into Roth IRAs.
Advantages of Roth IRAs. Roth IRAs vary from traditional IRAs in three main ways:
- Contributions to Roth IRAs are not deductible from gross income.
- Qualified distributions from Roth IRAs are tax-free.
- There are no minimum distribution rules applicable to Roth IRAs during the owner’s lifetime.
Thus, while Roth IRAs do not share the advantage of traditional deductible IRAs in allowing the taxpayer to recognize a current income tax savings, they allow for future income tax savings, as all contributions, growth and earnings will be distributed income tax free as long as the distribution is a “qualified distribution”. In general, a distribution will be treated as a “qualified distribution” if (i) it is made after the account owner has attained age 59½ and more than five (5) years after the account owner has first made a contribution to any Roth IRA, or (ii) it is made after the account owner’s death. In comparison, with a traditional deductible IRA while the growth and earnings are permitted to grow tax free, upon distribution, all previously non-taxed amounts are included in the recipient’s income and taxed at ordinary income rates. Furthermore, the minimum distribution rules do not apply to Roth IRAs during the account owner’s lifetime, so the taxpayer is not required to take distributions from the Roth IRA during life. Thus, to the extent the taxpayer does not need the funds, the funds can remain in the account growing income tax free and be passed on to the taxpayer’s beneficiaries at death. Note, the taxpayer’s beneficiaries will be subject to the minimum distribution rules.
Tax Effects of Conversion. In a conversion from a traditional to a Roth IRA, the amount converted in excess of the taxpayer’s basis in the IRA is included in the taxpayer’s income and taxed as ordinary income. For a traditional IRA where all amounts contributed have been deducted from income, 100% of the IRA converted would be included in the taxpayer’s income (note: to the extent non-deductible contributions have been made to the IRA, such previously taxed amounts would not be subject to tax on conversion). However, there is a special rule that applies for conversions in 2010 (unless the taxpayer elects out of the rule):
- None of the converted amount is included in income in 2010.
- One-half (½) of the income from the conversion is included in 2011.
- One-half (½) of the income from the conversion is included in 2012.
The taxpayer can elect out of this treatment if it is more advantageous to tax 100% of the converted amount subject to income tax in 2010. Again, this special rule only applies for 2010. So while under current law conversion is permitted in years subsequent to 2010, this special delayed taxation rule will not apply. Thus, if a taxpayer converts an IRA in 2011, 100% of the converted amount that is subject to taxation would be included in the taxpayer’s 2011 income.
Note: If a taxpayer makes a Roth Conversion in 2010, and later the account plummets in value or for some other reason the conversion becomes less advantageous for the taxpayer, the conversion can be “undone” if completed prior to the timely filing of the individual’s income tax return (including extensions).
Facts to Consider When Determining Advantage of Conversion. The determination of whether a taxpayer should consider converting part or all of their traditional IRA to a Roth IRA rests on many factors. Those factors that tend to favor conversion include:
- Current marginal tax rate lower than anticipated future marginal tax rate.
- Ability to pay tax on the conversion from sources other than the IRA.
- Expected growth in IRA assets.
- Significant period of time before funds are needed.
- Taxpayers with a desire to reduce the size of their estates for estate tax purposes
(income tax on the conversion is removed from gross estate and heirs receive funds on which income taxes have already been paid).
Contributions to a Roth IRA. Although the income limits on the ability to convert a traditional IRA to a Roth IRA have been removed for tax years beginning in 2010, the limitations remain regarding the adjusted gross income limits (AGI) permitted for contributions to a Roth IRA. The limits are subject to change each year in accordance with inflation rates, and for 2010 are as follows:
- Married Taxpayers Filing Jointly: For 2010, the maximum AGI for contribution is $177,000 (with a phase out of the maximum allowable contribution beginning at $167,000).
- Single Taxpayers: The phase out begins at AGI of $105,000 and is totally phased out when the AGI is equal to $120,000.
Note: for 2009 and 2010, the maximum amount that can be contributed to a Roth IRA is $5,000 and taxpayers who will attain at least age 50 during the calendar year are permitted an additional “catch-up” contribution equal to $1,000. Also note, that unlike traditional IRAs, a taxpayer can continue to contribute to a Roth IRA after age 70½ if the taxpayer has employment income and is within the income limits.
The foregoing is only a brief overview of matters to consider and the rules that apply to Roth IRA conversions. If you have any questions or want to discuss the opportunity further, please feel free to contact us.