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If you have been reading the business section of your local newspaper—or almost any financial magazine—then you are probably aware of the Roth IRA conversion option that presents itself on January 1, 2010.  However, while you may be familiar with the concept, I have found that many clients are uncertain as to whether this planning idea applies to them.  This piece is meant to shed some light on the subject.

Background

Individual Retirement Accounts (IRAs) have been around since the mid 1970s.  Traditional IRAs came to life as part of The Employee Retirement Income Security Act of 1974 (ERISA), and were designed to promote a tax-advantaged way for Americans to save for their retirement years.  At a basic level, the benefit allowed a taxpayer to deduct his or her IRA contribution off the current year tax return, and the money inside the account would grow tax deferred over his or her lifetime.  Federal and state taxes would not be due until the funds were withdrawn from the account, generally at retirement.  This IRA concept is still in existence today, but in the late 1990s an entirely new wrinkle was added.

As part of the Taxpayer Relief Act of 1997, Senator William Roth of Delaware introduced the Roth IRA.  While there are a number of distinctions between a Traditional IRA and a Roth IRA, there are two fundamental differences: Roth contributions are made on an “after-tax” basis (no upfront tax deduction), but the earnings in a Roth IRA accumulate tax free.  That means that 100 percent of an individual’s withdrawals from his or her Roth account at retirement are tax free (versus withdrawals from a Traditional IRA which are fully taxable at ordinary income rates).  Over the last decade, the Roth IRA has gained in popularity, and its utilization would be even more widespread if the IRS didn’t impose income limitations.  For 2009, Roth IRA contributions begin to get phased out for a single person when modified adjusted gross income exceeds $105,000 and $166,000 for a married filing jointly taxpayer (please note that one must have wages or earned income in order to be eligible to contribute to a Roth IRA, meaning that not all income can come from sources such as interest, dividends, capital gains, etc.).  As long as one meets the income requirements, an individual taxpayer can make an annual contribution of $5,000 to a Roth IRA ($6,000 for those over age 50).

In addition to making the annual contributions to a Roth IRA, many Americans also want to convert their Traditional IRAs to Roth IRAs in order to capture any future growth in a tax free manner, not simply tax-deferred, which the Traditional IRA provides.  Obviously, when an individual converts from Traditional to Roth, there will be a tax liability at the point of conversion, since no taxes have been paid on the Traditional account up to that point. You can rest assured that Uncle Sam and your state taxing authority want their tax money, so be ready to pay up!  However, there are also income restrictions that apply on converting to a Roth.  The IRS says that if your modified adjusted gross income exceeds $100,000 in 2009 (whether single or married), then you are not allowed to convert to Roth.

2010 Planning Option

Effective, January 1, 2010, the IRS is lifting the income cap restriction on converting Traditional IRA dollars to a Roth IRA. Beginning next year, many who have been prohibited from even considering such an idea in the past now have the option. Furthermore, the IRS has indicated that they are going to graciously allow taxpayers to spread the pain of the tax liability over two years versus paying all taxes owed at once.  Taking the IRS up on its offer to spread the tax over two years means the first tax year is 2011 and the second is 2012 (even though you did the conversion in 2010).  Keep in mind that if no new tax legislation is put into place over the next year, then the Bush tax cuts are set to expire on December 31, 2010.  Thus, you could potentially face a higher tax rate if you opt to take advantage of the two-year spread (you knew there had to be a catch).

Factors to Consider

The ultimate question for individuals is, “What’s the right answer for me?”  Wouldn’t it be nice if there was a decision tree or flowchart to help with this question?  The reality of this scenario is that there isn’t necessarily a right or wrong answer: the mission is to ascertain the best answer given the facts and circumstances facing you today.  Some of the arguments and considerations that have surfaced in recent conversations with clients revolve around the following:

  • What is my current tax rate today?
  • What do I expect my tax rate to be in the future?
    • If tax rates increase significantly in the future, money withdrawn from a Roth IRA won’t be impacted (no lifestyle infringement because of a tax rate increase).
  • I could do a partial conversion up to the point where I would hit the next tax bracket.
  • Given that Traditional IRA assets have been depleted from the recent market turmoil, it does seem to be a good time to consider a conversion, since the income recognized would be much less today.
  • Wouldn’t it be nice to capture any future market recovery in a tax free manner, not just tax deferred?
  • Given that Roth IRAs are not subject to the IRS’ Required Minimum Distribution requirements at age 70 ½ like Traditional IRAs, a Roth account can continue to grow tax free for a longer period of time.
  • Heirs of a Roth IRA are, in effect, receiving greater value, since they receive those same tax free distribution rights over their lifetimes.
  • Roth contributions are accessible immediately, both tax and penalty free.  Roth conversion amounts are accessible both tax and penalty free five years after conversion (even if not age 59 ½).
  • Even if I don’t qualify for making a Roth contribution today, I could still make a 2009 and 2010 “non-deductible” IRA contribution and then convert those dollars in 2010 (in effect it’s like making a Roth IRA contribution even though you’re not eligible).

Good News

Obviously, there are a number of variables that go into deciding whether or not to convert a Traditional IRA to a Roth IRA.  The good news is that your Moneta Family CFO is prepared to help you sort through this complex maze.

bio-ring-matt

Matthew D. Ring, CPA, CFP®

Mathew is the professional consultant for Tom O’Meara.