Roth IRAs: To Convert or Not to Convert?
You may have heard 2010 referred to as the year of the Roth. This is due to the fact that 2010 is the first year in which taxpayers may convert traditional IRAs and other qualified retirement plans into Roth IRAs regardless of income levels. Roth conversions have been available since 1998; however, eligibility to convert was limited to taxpayers with $100,000 or less modified adjusted gross income (MAGI). But even though you may now be eligible for a Roth conversion, it may or may not be the right choice for you. The question is a complex one for most taxpayers, which requires many assumptions about the future.
As a general rule, tax planners prefer to defer paying taxes on income today that can be put off into the future. However, there are always exceptions to the general rule and converting a traditional IRA and/or qualified plan funds to a Roth IRA may very well be one of these exceptions. The main premise being that upon conversion, the taxpayer would be paying tax now for the future right to tax free withdrawals.
Traditional IRAs vs. Roth IRAs
Traditional IRA contributions can be deductible, partly deductible or non-deductible. Contributions are always deductible if the taxpayer is not an active participant in an employer sponsored retirement plan, resulting in contributions that are pre-tax. Contributions grow tax deferred, until funds are distributed. At that point the funds are taxed as ordinary income.
Roth IRA contributions are never deductible, but earnings grow tax-free. Taxpayers may withdraw funds, including earnings; tax free if certain requirements are met.
Pros of Converting to a Roth IRA:
- Taxpayers expecting to be in a higher tax bracket in the future. You can hedge against the effect of expected higher income tax rates by converting traditional IRA funds to a Roth IRA and paying tax on the converted funds now. Many young professionals who expect their earnings to be substantially higher in the future may benefit from this strategy.
- Regular IRAs and other tax-favored retirement plans are subject to required minimum distribution rules, beginning with the first year subsequent to the owner reaching age 70 ½ and requiring minimum annual distributions . Roth IRAs are not subject to these rules until the death of the account owner. This is one of the Roth IRAs most attractive features, allowing the fund to continue to accumulate tax-free until death. This may appeal to taxpayers who do not expect to need the funds for living expenses upon reaching age 70 ½.
- Taxpayers with net operating losses, charitable donation deduction carry-forwards, or high basis IRAs (resulting from non-deductible contributions) may be able to offset all or part of the tax due to a Roth conversion.
- Taxpayers whose investments inside their traditional IRA that have recently suffered a substantial decline may benefit from converting now. With a Roth conversion, taxpayers pay tax on the converted amount. Paying tax on the deflated value may save future taxes on distributions if the investments rebound in the future.
- Taxpayers considering moving to a high tax state, from a previously low or no income tax state may benefit by converting now and avoiding future state taxes on distributions (the taxable amount of a Roth conversion is considered taxable income by the State of Arkansas).
- Recently widowed taxpayers may benefit from a Roth conversion. Taxpayers get the benefit of the married filing jointly tax brackets in the year a spouse passes away. Making a conversion in the year of a spouse's death, could keep future distributions from being taxed at a single taxpayer's rate.
- Taxpayers that desire to leave a tax free pot to heirs may benefit from converting to a Roth. Non-spouse beneficiaries of Roth IRAs may be able to elect to withdraw the IRA funds over their life expectancy, allowing the Roth IRA funds to continue to earn tax-free income while also receiving tax-free distributions.
- Taxpayers who expect to have a taxable estate would reduce the size of their estate by the amount of current taxes paid on a Roth conversion. Although the estate tax has not been in effect for 2010, barring any action from Congress, the estate tax will be reinstated in 2011.
- Converting to a Roth may decrease the amount of taxable Social Security in the future. Up to 85% of Social Security may be subject to tax, depending on the amount of the taxpayers other income in the year it is received. Since Roth distributions are not taxable income, as opposed to distributions from other tax favored retirement plans, they do not affect the amount of Social Security subject to tax.
- The recent passing of the new Healthcare Act brought with it a 3.8% Medicare surtax on investment income to the extent modified adjusted gross income exceeds certain levels, to begin in 2013. Roth IRA distributions are not considered investment income for this tax; they do however figure into the calculation of MAGI and could increase the amount of other investment income subject to the 3.8% Medicare surtax for higher income taxpayers.
Cons of Converting to a Roth IRA:
- Taxpayers that expect to be in a much lower tax bracket after retirement most likely would not be good candidates for conversion.
- Taxpayers that do not have non-IRA funds to pay the tax. Paying the tax from IRA funds would cause you to lose the potential benefit of tax free growth on that amount defeating the purpose. This is further compounded if you are not 59 ½, as the withdrawal to pay the tax would be subject to the early withdrawal penalties.
- Taxpayers nearing retirement and expecting to need the funds to live probably should not make a conversion. It may take years or even decades for the tax-free growth of a Roth to recover the current cost of paying taxes on the amount converted.
- Converting may cause unintended tax consequences. For example, if the conversion increases taxable income for the current year, it may push the taxpayer into higher tax brackets or limit the taxpayer's ability to deduct certain expenses such as medical expenses that are not deductible until they exceed 7.5% of AGI.
- Taxpayers planning to move from a high income tax state to a low or no income tax state in the future might want to consider waiting until after they move to avoid the current higher state income taxes on the conversion.
- Taxpayers with creditor issues may receive better asset protection by leaving retirement funds in a 401(k) or other qualified plan. These taxpayers would need to consult a lawyer before making the decision to convert to a Roth IRA.
- Taxpayers who are enrolled in Medicare Part B should consider the effect of a Roth conversion on Medicare premiums. A current year increase to income from a Roth conversion could increase the amount of social security that is taxable and in some cases could cause an increase in Medicare premiums. This is not a factor for taxpayers reporting the income on a tax return at least two years prior to their first year in the Medicare Part B program.
Paying the Conversion Tax:
In 2010 there is an option to report the entire amount of income from a conversion on your 2010 return and pay all of tax in 2010 or to spread the income out over the next two years. If the two year option is selected, half of the income is reported on your 2011 return and half on your 2012 return. The tax due is based on your income tax rates for that year, so your actual tax due on the amount converted could be different from 2011 to 2012 if you are in different tax brackets. This option only applies to conversions that take place in 2010. Conversions after 2010 will be reported in total in the year of conversion.
As mentioned previously, paying the tax from IRA funds is never a good idea. Ideally you have the funds available elsewhere to pay the tax from the conversion. However, when considering whether or not to convert you will want to take into account the "opportunity cost" of what the money could have earned if left invested as is.
Other Factors to Consider:
Upon deciding to convert to a Roth IRA, consideration should be given to dividing the assets being converted into multiple Roth accounts based on asset class. This positions the taxpayer to possibly be able to reverse the conversion depending on investment performance with an IRA recharacterization should the need arise, for instance if the value of one class of assets substantially declines shortly after conversion. Taxpayers have until October 15 of the year following the conversion to switch back to a traditional IRA.
Some high income taxpayers may think that they could not continue to contribute to a Roth IRA after a conversion due to income limits. There may be a way around the income limits, by making non-deductible traditional IRA contributions and then converting these to a Roth IRA. If you have other qualified retirement funds, the IRS does not allow you to cherry pick the assets to convert, and you may have to pay a pro rata tax on the non-deductible IRA upon conversion.
Husbands and wives can both convert their own funds. One can choose to report the income in 2010 and the other could choose the previously mentioned two year deferral.
It is not all or nothing with a Roth conversion. Partial conversions can be made as a means of diversifying overall tax risk.
As you can see the question is complex, with many factors to consider before deciding to take the plunge. As you read this article, time is running short and we are quickly approaching the end of 2010. If planning to make a Roth conversion in 2010 it is time to start considering all of the factors involved. If you have questions, please let our experienced tax professionals assist you in the decision making process.
