Converting Retirement Assets from a Traditional IRA To a Roth IRA Presents a New Opportunity beginning 2010

New Rules Pave Way for More Individuals to Generate Tax-Free Income at Retirement.

The hurdles to building retirement savings can be high in today’s economy and volatile markets, so it pays to examine any opportunity that makes meeting the retirement income challenge potentially easier. Taxes eat away at retirement assets when they are withdrawn from traditional Individual Retirement Accounts (IRAs), but many higher-income earners – generally an adjusted gross incomes of $100,000 or more – have not had an opportunity to take advantage of a Roth IRA, which is funded with after-tax contributions, grows tax-deferred and generally incurs no income taxes at distribution (provided certain requirements are met).

Starting in 2010, higher income earners are able to readily convert their traditional IRA to a Roth for the first time since the Roth IRA was created in 1997. (Taxpayers with less than $100,000 in modified adjusted gross income didn't have to wait until 2010 – they could convert anytime.) The Roth conversion opportunity is not limited to traditional IRAs – an eligible rollover distribution of a portion or all of the assets in any employer provided tax-qualified retirement plan, such as a 401(k), can be converted, too, and the portion of the eligible rollover distribution that consists of after-tax contributions will not be taxed. There are a number of reasons why converting to a Roth IRA could be a fruitful strategy at this time:¹

• Many IRA accounts have lost significant value over the past year or two, so the total tax bill on the tax-deductible contributions and earnings may be less than it otherwise would have been.²

• Under the new rules, if the conversion to a Roth IRA takes place in 2010, the gross income subject to tax as a result of the conversion can be spread out to 2011 and 2012 – half in each year, thus lessening the immediate impact of the tax and possibly avoiding being pushed into a higher tax bracket in the conversion process.

• Funds in a Roth can be left to grow beyond age 70 ½, when regular withdrawals must begin from a traditional IRA.³

• While income limitations on direct Roth contributions remain, with no income limits on conversion, the effect of these income limits on contributions is migrated, so an individual up to age 70 ½ could open a traditional IRA, and then immediately convert those assets to a Roth.

Conversion to a Roth IRA of course may not benefit everyone who is newly eligible, and it is important to consult your financial advisor and/or your accountant. Current and estimated tax rates at retirement are important factors. An advisor can crunch numbers to calculate whether the money used to pay taxes on the conversion to a Roth is less than the present value of future tax savings on distributions. Moreover, if taxes on a conversion can be paid from funds outside the IRA, that permits an individual to save more for retirement in a tax-advantaged way, assuming his or her tax bracket does not drop significantly once retirement begins.⁴ The ideal is to have cash on hand to pay taxes in 2011-2012 on a conversion in 2010. Fees, age at conversion, and possible changes in the tax laws should all be weighed.

Not all the factors involved in the conversion decision are purely quantitative either. Overall retirement needs and plans are important, too. For example, the Roth IRA route could be better for someone who wants to pass on an income-tax-free inheritance to children and grandchildren.⁵ For those people who have substantial assets, conversion to a Roth could make sense for estate planning purposes.

The new Roth opportunity is certainly worth a conversation with a professional advisor. It could be time well spent.
 

For more information on Roth IRA conversions, please contact us.

1. However, this opportunity may not be right for everyone. For instance, paying taxes now may not outweigh the benefit of tax free retirement income in the future, so an individual who is converting for the tax benefit of generating tax free retirement income must consider their individual circumstances, including their age, to determine if a Roth IRA conversion is right for them.
2. The taxable amount converted will be taxed as ordinary income. Generally, the taxable amount consists of any pre-tax contributions and tax deferred earnings. However, if the conversion involves an annuity contract, the taxable amount may be based on more than just the account balance because it may include the actuarial present value of any additional benefits (living and death benefits) provided under the contract along with the addition of certain loads and charges, which were deducted from the account balance during the immediately preceding 12 months.
3. While the Roth IRA owner is not subject to the lifetime required minimum distribution rules, his or her beneficiary will still have to comply with the after-death required minimum distribution rules (unless the sole designated beneficiary is the Roth IRA owner’s spouse and the spouse elects to continue the Roth IRA as the spouse’s own).
4. If the Roth IRA owner converts before attaining age 59 ½ and does not convert the full amount distributed or treated as distributed from his or her IRA (including amounts withheld for or used to pay income taxes), the taxable amount not converted will not only be subject to ordinary income taxes, but may also be subject to a 10% federal income tax penalty.
5. In addition to the possible estate taxes that may be imposed on your assets at your death, the generation skipping transfer tax may apply if you name your grandchild as the beneficiary of your IRA or Roth IRA. Please consult your own independent tax advisor before naming your grandchild as your beneficiary.

Any discussion of taxes herein or related to this document is for general information purposes only and does not purport to be complete or cover every situation. Tax law is subject to interpretation and legislative change. Tax results and the appropriateness of any product for any specific taxpayer may vary depending on the facts and circumstances. You should consult with and rely on your own independent legal and tax advisers regarding your particular set of facts and circumstances.