Starting in 2010, all taxpayers will be eligible to convert a regular IRA to a Roth IRA, regardless of their level of adjusted gross income ("AGI"). The option opens new opportunities, but also may require important tax planning. This article will discuss the new rules for conversion of a traditional IRA to a Roth IRA and the issues a taxpayer should consider before converting.
CURRENT CONVERSION RULES
Under the current law, a taxpayer (other than a married person filing separately) can convert all or part of a regular IRA to a Roth IRA if the taxpayer's AGI is $100,000 or less. A SEP-IRA or a SIMPLE IRA may also be converted, but in the case of a SIMPLE IRA the taxpayer must have participated in the SIMPLE IRA for at least two years.
For purposes of eligibility to convert a regular IRA to a Roth IRA, AGI does not include income resulting from the conversion itself, nor does AGI include any required minimum distribution from an IRA. Conversion from a regular IRA to a Roth IRA is treated as a distribution and requires the taxpayer to include the converted amount in income. However, the 10% early withdrawal tax for distributions prior to age 59½ does not apply.
CHANGES IN 2010
Revisions to the conversion rules were made by The Tax Increase Prevention and Reconciliation Act of 2005. The changes:
- Repeal the $100,000 AGI limit for eligibility to convert
- Permit conversions by married taxpayers filing separately
- Allow a taxpayer who converts in 2010 to elect not to report the includable income in 2010. Instead, half can be reported in 2011 and half in 2012
The elimination of the $100,000 AGI eligibility limit opens the conversion opportunity to any taxpayer who has a regular IRA. The question, of course, is whether a taxpayer should convert, and if the taxpayer converts, should the special tax reporting rule be elected?
WHY CONSIDER A CONVERSION?
It is generally believed that a Roth IRA is preferable to a regular IRA. First, distributions from a regular IRA are taxable as ordinary income. Under a Roth IRA, however, distributions of both the contributions and the earnings are tax-free, so long as they are "qualified distributions." To be a "qualified distribution" the Roth IRA must have been held for at least 5 years and the distribution must be received after age 59 ½ (or on account of death or disability).
Second, regular IRAs are subject to rules requiring that distributions begin no later than the year following the year the taxpayer attains age 70½. Roth IRAs are not subject to the required minimum distribution rules. This means the Roth IRA can be held after age 70½, and until death, without any required distributions (beneficiaries of a Roth IRA are subject to required distribution rules). The Roth IRA, therefore, allows a pass-through of tax-free income to the taxpayer's heirs.
Other advantages of the tax-free payments from a Roth IRA include keeping a taxpayer in a lower tax bracket than would otherwise apply if taxable distributions were received from a regular IRA; tax-free Roth IRA distributions will not enter into the calculation of tax owed on Social Security benefits; and tax-free Roth IRA distributions will not affect AGI-based itemized tax deductions which otherwise are phased out based on the taxpayer's AGI.
WHO SHOULD CONVERT?
Although there are always exceptions, it is generally thought that conversion should be considered by taxpayers who:
- Can afford to pay the taxes resulting from a conversion by using other assets. If they need to use dollars from the converted IRA itself to pay the taxes, the resulting future lower earnings in the Roth IRA will not be worth the conversion.
- Have a number of years to go before retirement, so they are able to regenerate the funds used to pay taxes on the conversion.
- Believe they will be in a higher tax bracket in later life than their current tax bracket.
- Do not contemplate needing the funds in the IRA for retirement expenses, so the Roth account can be held tax-free and passed to the taxpayer's heirs. If this is the case, it should also be noted that paying the income tax from other assets on conversion to the Roth IRA will also reduce the taxable estate for estate tax purposes.
- Lost a great deal of value in the stock market in 2007 and 2008 and have not had their account balance recover. With the lower value of the regular IRA, now might be an ideal time to pay lower taxes on the current value, convert to a Roth IRA, and enjoy the recovery in the tax-free Roth.
IF YOU CONVERT IN 2010, WHEN SHOULD YOU PAY THE TAX?
The reason Congress repealed the $100,000 eligibility limit for conversion was to encourage higher income taxpayers to convert to a Roth IRA, and thereby pay taxes on their regular IRA now rather than in future years. It is felt that the change will raise significant revenue for the federal government. To further encourage the conversion, Congress gave taxpayers two years to pay the taxes due (2011 and 2012).
Will it make sense to defer the income tax from 2010 to 2011 and 2012?
Without further action by Congress, after 2010 tax brackets will revert to their pre-2001 levels. That means the highest four brackets will be 39.6%, 36%, 31%, and 28% instead of the current brackets of 35%, 33%, 28% and 25%. President Obama has proposed increasing taxes only for those making over $250,000, but it is impossible to predict who will see higher tax brackets. Predicting future tax rates is even more difficult because of the proposals to help fund health care reform with a surtax on higher income taxpayers.
Given the real possibility of increased tax rates for higher income taxpayers beginning in 2011, a prudent decision might be to pay the entire tax bill generated by conversion to a Roth IRA in 2010 rather than pay the taxes in 2011 and 2012.
PLANNING DURING 2009
If a taxpayer intends to convert a regular IRA to a Roth IRA, here are some tax planning ideas to consider:
- Lower income earners who are eligible to make deductible IRA contributions in 2009 should do so. This will reduce their 2009 taxes and, upon conversion in 2010, they can pay the taxes in 2011 and 2012.
- Higher income earners who have not made deductible IRA contributions in the past (and have not rolled over from a qualified plan to an IRA) should consider making nondeductible contributions to a regular IRA for 2009. In 2010, the regular IRA can be converted to a Roth IRA, and the only taxable amount will be the earnings for 2009. (If the taxpayer made deductible IRA contributions in the past or rolled assets over from a qualified plan to an IRA, complicated rules apply in determining the taxable amount upon conversion to a Roth IRA. In that case, it is NOT possible to just convert the nondeductible amounts held in the IRA.)
- A higher income earner who plans on converting in 2010, and to pay the tax in 2010, should avoid the "usual" tax planning strategy in 2009 of accelerating deductions and deferring income. To the contrary, they should accelerate income to 2009 and defer deductions to 2010 to the extent possible.
ROTH IRA CONTRIBUTIONS
The contribution rules for a Roth IRA have not been changed. Therefore, although the taxpayer may convert a regular IRA to a Roth IRA in 2010 without regard to AGI, new contributions may not be made to the Roth IRA if the taxpayer's AGI exceeds the eligibility limit. In 2009, the eligibility limit is AGI of $120,000 for single taxpayers and $176,000 for married taxpayers filing jointly.
If you would like to discuss a Roth conversion, please contact your WN&J Employee Benefits attorney.