In 2010, Roth IRAs may become the retirement arrangement of choice for many taxpayers. This is because new tax rules now make these types of plans available and more attractive to many additional taxpayers. Generally, the new rules allow for converting an existing traditional IRA (hereinafter “Traditional Account”) into a Roth IRA (hereinafter “Roth Account”). Similar, but somewhat more complex new rules also apply for some employer-based qualified plans where you can convert the non-Roth portion of your vested account balance in a 401(k), profit sharing, money purchase, pension, 403(b) or 457 plan into a Roth Account.
If a taxpayer chooses to convert, federal income tax will be owed on the amount converted. However, in 2010, that tax can be paid over two years, ½ in 2011 and ½ in 2012. In addition, the 10% penalty for early withdrawal will not apply to amounts rolled over that remain in the Roth Account if they are later part of a qualified distribution. More importantly, once conversion takes place, the amount converted will grow tax-free and can be withdrawn tax-free, or can remain in the Roth Account without being subject to minimum distribution rules.
If you currently have funds in a Traditional Account (or in some cases an employer-based qualified plan), converting those funds into a Roth Account may present you with a significant tax savings opportunity.
The purpose of this eFocus is to provide you with an executive summary of the rules relating to Roth conversions and what you should consider when determining whether a conversion makes sense for you. This eFocus is not a replacement for professional advice. Deciding whether to convert or not convert is not a “one size fits all” proposition and many things need to be considered. As always, your RubinBrown professional advisor will be more then happy to assist you in analyzing your specific situation.
In 2010, the rules regarding converting a Traditional Account into a Roth Account have changed. In 2009, you were only able to convert if your modified adjusted gross income (MAGI) was $100,000 or less and you did not file a married filing a separate federal income tax return. However, in 2010, both the income and filing restrictions have been removed. This means that many more taxpayers, including affluent and higher income taxpayers, may be able to take advantage of the potentially favorable tax consequences offered by the new conversion rules.
Differences Between Traditional and Roth Account
To fully grasp the potential benefit of the new conversion rules, it is important to understand the differences between a Traditional Account and a Roth Account.
With a Traditional Account, contributions are tax deductible. The assets in the account thereafter build-up tax free. When distributions are made, it is time to pay the piper. That is, distributions from a Traditional Account are taxed at ordinary income rates and subject to the 10% early withdrawal penalty unless you are over the age of 59 ½ or satisfy one of the statutory exceptions (death, disability, etc.). Further, a taxpayer is not allowed to keep funds in a Traditional Account forever. Under minimum distribution rules, taxpayers must begin to take distributions from their account at a certain age (e.g., age 70 1/2 for traditional IRAs).
With a Roth Account, contributions are not tax deductible when made and there is therefore no immediate tax savings that are generated in the year of the contribution. As with the Traditional Account, assets build-up tax free. Generally, Roth Account distributions are tax-free when funds are withdrawn if they are qualified distributions made to you or your or beneficiary after attainment of age 59 ½, death or disability, and at least 5 years after the tax year of the first Roth contribution. Further, a Roth Account is not subject to minimum distributions rules which means funds can grow tax-free longer and can ultimately be passed to the next generation free of income tax.
The Pros and Cons of Converting
If a Traditional Account is converted into a Roth Account, the amount converted is taxable income. For 2010 only, you can defer the income and pay the tax over two years, ½ in 2011 and ½ in 2012. Thereafter, the amount in the Roth Account builds up tax-free and qualified distributions can be withdrawn tax-free. In addition, a taxpayer with a Roth Account will not be subject to minimum distribution rules and therefore will not be required to take funds out of the account at any particular age. The value of the benefits of tax-free withdrawal and no required minimum distribution rules may more than offset the negative impact of having to pay taxes currently.
Steps or Considerations for Roth IRA or Traditional Account Conversions
Whether converting an existing Traditional Account into a Roth Account makes sense for you depends on a number of factors. We would suggest that at a minimum a person contemplating conversion should consider and/or evaluate the following:
- Evaluate Current Traditional Account
- Weigh Tax, Financial and Other Factors
- Calculate Potential Tax Due and Analyze When to Pay Tax
- Analyze When to Convert
- Seek Professional Assistance
Evaluate Current Traditional Account
A person contemplating conversion should get a grasp on what assets are in their Traditional Account and are therefore eligible for conversion into a Roth Account. The higher the value of your Traditional Account, the higher your tax will be if you convert. However, if your Traditional Account has decreased in value over the last couple of years due to the economy, you will not owe as much in tax compared to the time when the balance was higher. This could mean that it makes more sense to convert because values are lower then they were or will be once the economy rebounds.
You should also note that conversion is not an all or nothing proposition. That is, you are allowed to convert some, but not all, of the balance in your Traditional Account into a Roth Account.
Weigh Tax, Financial and Other Factors
The decision to convert depends on a number of personal factors such as a person’s age, current and projected tax brackets, ability and source of funds to pay the tax caused by the conversion, and how long it will be before it becomes necessary to tap into the retirement account. Consideration should also be given to any non-tax differences between Traditional Accounts and Roth Accounts, such as creditor or bankruptcy protection under federal and state law.
Calculate Potential Tax Due and Analyze When and How to Pay Tax
It is advisable to figure out the tax due on conversion. You will owe federal and state tax on the contributions and gains in your Traditional Account for the amount converted.
For conversions in 2010, you can elect to recognize income over two years. Therefore, a taxpayer who converts in 2010 will not have to pay federal tax on these amounts until 2011 and 2012. You should note that State income tax treatment may differ from federal tax treatment. You should therefore understand the particular tax consequences for your State.
Whether it is advisable to spread the tax over two years or pay it all in one year is another decision you need to make. Although deferring the tax payment over two years may make sense, there are two important factors to consider. First, if tax rates increase between 2010 and 2012, what effect will that rate increase have on your total tax? Second, conversions become more beneficial if the tax is paid with funds not taken from your Traditional Account. For some taxpayers, spreading the tax payment over two years may allow for other non-qualified funds to pay the tax.
Analyze When to Convert
The timing of the conversion is another factor to consider. For a lot of taxpayers, the sooner a conversion takes place, the better. This allows more time for assets to appreciate in the Roth Account, assuming the market continues to rebound. If, however, you are not sure what your income or projected tax bracket will be in 2010, you may want to consider converting later so that you have a clearer tax picture.
Seek Professional Assistance
The decision to convert requires an analysis of a lot of moving parts. If you believe that conversion may be appropriate for you, it is advisable to seek out professional assistance to help you through the conversion rules and how they apply to your specific situation. RubinBrown would be happy to assist you in this endeavor.
When a Roth Conversion May Make Sense
Although whether converting a Traditional Account to a Roth Account makes sense for an individual is dependent on that person’s particular situation, a conversion may make sense in the following cases:
- Taxpayer will not need access to money in the Roth Account for at least five years after Roth Account established;
- The tax due on conversion can be paid from sources other than IRAs or qualified plan assets;
- Taxpayer will be in the same or lower tax bracket in 2010 than the one expected at retirement;
- Taxpayer’s retirement account took a beating in the market and has not fully recovered, but taxpayer expects it to recover;
- Taxpayer wants to build an estate for heirs and minimize the future tax burden for the family;
- Taxpayer wants to continue to contribute to a retirement account after age 70 ½.
2010 may be a one-time opportunity for you to convert a Traditional Account into a Roth IRA because of the new tax rules. You should review your tax and financial situation to determine whether this opportunity is right for you.
Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.
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