Beginning in 2010, many high-income individuals will be allowed to convert their traditional IRAs to Roth IRAs. On January 1, 2010, the income limits for individuals converting to Roth IRAs will be eliminated. This change happens at a time when many IRA accounts have declined in value and tax rates may be relatively low.
Types of IRA Accounts
The two most common types of individual retirement accounts are traditional IRAs and Roth IRAs. They are similar in that both allow for tax-deferred growth inside the account. The difference between the two is how the account is taxed at the time of the contribution and withdrawal. With a traditional IRA, your contributions are generally tax-deductible when they go into the account, but you will be taxed when you withdraw the money at retirement. With a Roth IRA, you get no tax deduction when the contributions are made to the account, but the withdrawals from the account are tax-free at retirement, as long as you have attained age 59.5 and satisfied a five-year holding requirement.
In 2009 and prior years, individuals were not allowed to convert their traditional IRAs to Roth IRAs if their adjusted gross income exceeded $100,000 or if the filing status on their tax returns were “married filing separate,” unless they lived apart from their spouses for the entire year. As indicated above, the income limit has been removed beginning January 1, 2010. In addition, the rule against conversion by those with a filing status of “married filing separate” no longer applies. This has opened the opportunity for many high-income individuals to reposition all or a portion of their individual retirement accounts in Roth IRAs.
Tax Consequences of a Conversion to a Roth IRA
Conversion from a traditional IRA to a Roth IRA is a taxable event. You will be taxed on any amount that would have been taxable had you taken a distribution directly from the traditional IRA. However, the 10-percent early withdrawal tax penalty does not apply to the amounts converted to a Roth IRA. In addition, special tax rules apply for conversions occurring in 2010. The taxable portion of the 2010 conversion is included in your taxable income in equal installments in 2011 and 2012, unless you elect otherwise. Accordingly, unless you elect differently, none of the conversion amount will be taxed in 2010. Instead, half will be taxed in 2011, and the other half in 2012.
Items to Consider for Roth Conversion
The decision to convert a traditional IRA to a Roth IRA is dependent on many factors and is unique to each individual’s situation. Some potential benefits to a Roth IRA conversion are as follows:
- Tax-free distributions. As mentioned above, the contributions to a Roth IRA are made with after-tax dollars, but the distributions are tax-free.
- Avoiding required distributions. Unlike a traditional IRA, a Roth IRA has no required minimum distributions at age 70.5. Your Roth IRA can continue to grow tax-free, and you have control over when and how much you withdraw. In addition, any Roth IRA accounts that are distributed to your beneficiaries upon your death are tax-free distributions to the beneficiaries.
- Estate-tax savings. Most individuals do not have to worry about the federal estate tax because of the credit that effectively exempts a large dollar amount from the tax. However, if you have accumulated enough wealth to be subject to the estate tax, converting to a Roth IRA could likely reduce that tax burden. By paying the tax on your IRA at conversion, you are reducing the size of your estate by the amount of tax paid, and therefore reducing your estate tax liability.
- Conversion of nondeductible IRA. Individuals who have made nondeductible contributions to traditional IRAs can likely convert those IRAs to Roth IRAs with minimum tax consequences. They would only pay tax at conversion on the earnings of the nondeductible IRA. In addition, individuals who are not eligible to make Roth IRA contributions are allowed to make nondeductible traditional IRA contributions and then convert them to Roth IRAs.
- You can pay your taxes on the conversion with money outside the IRA account. If you have the funds available to pay the taxes on the conversion with money outside the IRA account, the entire balance of the IRA can be converted to a Roth IRA, increasing the amount available for tax-free growth (if you are under age 59.5, you must pay the tax with funds outside the IRA account to avoid the 10-percent early-withdrawal tax).
- Your IRA account may be at a low point. With the decline in the stock market, many IRA accounts have depressed values. Converting to a Roth IRA may cost you less in taxes because of the lower values and provide potential opportunity for more tax-free growth when the stock market recovers.
Conversions from Eligible Retirement Plans to Roth IRAs
Beginning January 1, 2008, distributions from tax-qualified plans such as 401(k), profit sharing, money purchase, 403(b) and 457 plans can be rolled directly into a Roth IRA. These rollovers are subject to the same restrictions that apply to conversions from a traditional IRA to a Roth IRA as discussed above.
The changes that are taking place with respect to Roth IRA conversions provide a valuable retirement planning opportunity. However, you need to consider many factors as they relate to your personal situation to determine if a Roth IRA conversion is the right choice for you. iBi