Napier & Company, LCC

2010 Roth Conversion Opportunities and Pitfalls

Beginning in 2010, the rules for converting a traditional IRA to a Roth IRA will change so that everyone will be eligible. So, now that you know you can do a conversion, should you? As a general rule, tax planners advise against paying a tax today when you can wait to pay it at a later date. However, this article is going to explore the Roth conversion opportunity and things you should consider before doing a conversion.

First some background on Traditional and Roth IRA’s

Traditional IRAs:

• If you qualify to make a contribution into a traditional IRA account, the contribution is tax-deductible.

• If you are covered by a qualified employer-sponsored retirement plan, like a 401(k) plan, and you are a single tax filer, a traditional IRA contribution is fully deductible for 2009 only if your modified adjusted gross income is $55,000 or below. If you're a married couple filing jointly, the ability to deduct your contribution phases out between $89,000 and $109,000.

• Even though traditional IRA distributions are taxed at ordinary income tax rates, it can still make sense to contribute if you are eligible to receive an up-front deduction. However, because long-term capital gain and qualified dividend tax rates are currently lower than ordinary income tax rates, a nondeductible contribution to a traditional IRA rarely makes sense. In that case, there is no up-front deduction, and earnings are eventually taxed at higher ordinary income rates when withdrawn.

Roth IRAs:

• Contributions to a Roth IRA are not tax-deductible, but earnings can be withdrawn income-tax-free if you're at least 59½ and have had the Roth at least five years.

• You do not need to take required minimum distributions starting at age 70½, as you do with a traditional IRA.

• For 2009, the ability for single filers to contribute to a Roth IRA phases out if your modified adjusted gross income lies between $105,000 and $120,000 for single filers. For married filing jointly, the eligibility phases out between $166,000 and $176,000.
The maximum contribution that you can put in for 2009 to either a traditional IRA or Roth IRA is $5,000. If you’re 50 or older, you can contribute an additional $1,000. You can choose either type of account or contribute to both, but your total contribution cannot exceed the maximum amount allowed.

So, if you qualify to be able to put funds into both a deductible traditional IRA and a Roth IRA, which one makes the most sense? Well, it will depend on the facts and circumstances of each case, after all this is the Internal Revenue Code we are talking about, but here are some guidelines.

Should you contribute to a Regular or a Roth IRA?

• The more years you have until you take the funds out of the IRA, the more the Roth IRA may make the most sense. This is because it will provide more years of potential growth for the funds to come out completely free of tax.

• Another consideration is your tax bracket now vs. your tax bracket in retirement. If you think your income tax bracket will be the same or higher when you retire than it is today, then a Roth IRA probably makes more sense than a traditional IRA.

• If you think your income tax bracket will be lower when you retire, you may be better off taking the up-front deduction of a traditional IRA.

Roth IRA conversion – What is it and how does it work?

For a number of years now, the tax code has allowed you to convert your regular IRA into a Roth. Since the funds in the regular IRA have never been taxed (unless there have been non-deductible contributions made) they need to be taxed upon conversion since the Roth funds come out free of any tax.

There are some rules on the conversion through 2009. You cannot convert from a traditional IRA to a Roth IRA if your modified adjusted gross income on your federal income tax return is over $100,000. Beginning in 2010 (and beyond) this limitation is eliminated and anyone with any amount of income can make a conversion. In addition, there's a special rule in place for 2010 only that will allow you to recognize 100% of the conversion income in 2010 or split it into multiple years so that you pay the tax over time in 2010, 2011 and 2012.

Even though you have to pay current income tax on the amount you convert to a Roth IRA, it still might make sense if:

• You think you will be in the same or a higher tax bracket when you withdraw,

• You have a relatively long time horizon, and

• You can pay the tax from sources other than your IRA, such as from regular taxable brokerage or bank accounts.
Another reason to do the Roth conversion is if you do not need to use the money in your retirement years and you want to leave an income-tax-free Roth IRA to your heirs for gift and estate-planning purposes. This is due to the fact that you do not have required minimum distributions that have to be taken from Roth IRAs.

Some items to consider:

• As outlined above, there will be taxes to pay on the amount converted. If you pay the tax from the IRA funds then you lose the potential benefit of tax-free growth on that amount. In addition, if you’re under 59½, you would also incur a 10% federal penalty. So if you do a conversion, you will want to have enough cash on hand to pay the conversion tax without dipping into the actual IRA funds.

• Due to the economy, 2009 and possibly future years, may be low taxable income years. Given this, these may be a good years to convert so that you maximize this situation.

• Assuming you have the cash available elsewhere to pay the conversion tax, you still need to account for the “opportunity cost” of what that money could have earned had it remained invested in a taxable account. This requires making broad assumptions about the rates of return and tax brackets, but we bring it up as a point of consideration for you.

• Values of most IRA accounts are down, this means that the value that gets converted into the Roth IRA, and subsequently taxed, is also down. This may be an opportunity to convert while the values are down now and then gain the value back in the Roth IRA and never be taxed on this increased value since Roth IRA amounts are never taxed.

Who most stands to gain by the 2010 change?

The primary reason for the conversion change was to accelerate the collection of income taxes that might otherwise be locked up in traditional IRAs for decades to come. That being said, who is most likely to gain from this tax change?

For those with incomes between $100,000 and $250,000, the newfound eligibility for a Roth conversion might be worth a closer look since these taxpayers were not allowed to convert in prior years.

High net worth individuals may find that converting part or all of a traditional IRA to a Roth is advantageous for estate-planning purposes, especially if there is a significant IRA balance that doesn’t need to be tapped during the owner’s lifetime. Though the value of a Roth will still be included in the gross estate, because there are no required minimum distributions, the account could grow larger than it otherwise might under traditional IRA due to the required minimum distribution rules.

We hope that you find this article helpful. If you have any further questions, please feel free to contact us for a discussion.