Roth IRA Conversions

by Steve Benevento

Roth IRA conversions have been a hot topic recently. No surprise considering that as of January 1, 2010, the $100,000 income limit on conversions will be removed. While this means anyone will be able to convert, it doesn’t answer the question whether or not a conversion is best for you.

Converting to a Roth IRA is a taxable event. Even though the market has come roaring back since bottoming out on March 9, 2009, it is still well below its peak of October 2007. And lower account values means less tax due. For conversions that occur in 2010 only, the IRS allows you to spread the tax due over the following two years (2011 and 2012). The amount taxed is treated as ordinary income, however, and 2011 coincides with the expiration of previous legislation that had temporarily reduced tax rates. So, depending on your income, you may end up paying more taxes by opting for this benefit.

The Basic Rules

When deciding to convert there are some basic rules. First, if you don’t have the funds available outside of the IRA to pay the tax that will be due, you probably should not convert. If you are under age 59½ and use the IRA funds to pay the tax, you will be subject to an early withdrawal penalty. The ideal candidate for a conversion is someone who expects to be in a higher tax bracket when distributions will be required from the traditional IRA, does not need money from the IRA and would actually prefer to avoid future required minimum distributions (RMDs), and is looking for an estate planning tool to pass funds to an heir that will not be subject to income tax.

Consider Partial Conversion

But financial planning is never this straightforward. For many people a partial conversion may be optimal. Under current law the ability for anyone to convert, fully or partially, will continue after 2010. This allows you to convert an amount up to the level that will bring you to the top of your marginal tax rate. This also gives you the ability to lower the eventual RMDs from the traditional IRA at age 70½, thereby avoiding being pushed into a higher tax bracket.

Shifting Income Tax Rates

The most important variable mentioned above is the potential change in income tax rates. Yet future tax rates are hardly a certainty. You may be better off applying a technique that we are all familiar with when it comes to our investment portfolios: diversification. But in this case it is diversification of taxability. The best way to hedge against the uncertainty of future tax rates is to save for retirement with taxable, tax-deferred, and tax-exempt assets. Partial conversions lend themselves to this concept as well.

Roth IRAs may be used as an estate planning tool for larger estates. Avoiding RMDs at 70½ and beyond can result in a significant increase of wealth transferred to heirs. While the beneficiaries of a Roth IRA are subject to RMDs, the amounts distributed are income tax free. Currently, estates subject to the estate tax (those over $3.5 million) pay a flat rate of 45 percent. It seems likely, based on the introduction of recent legislation, that a temporary extension of current rates and exemptions will be put into place for 2010. Conversions done now will be subject to income tax, which, even for those in the highest income bracket, is lower than the current estate tax.

Additionally, the payment of the taxes due on a conversion, although from a source other than the IRA, will still lower an estate’s overall value subject to estate tax. (Clients with charitable goals should be aware that other considerations apply.)

Roth IRA Contributions

The elimination of the conversion limit does not mean that anyone can contribute to a Roth IRA. The contribution rules still apply. Anyone can currently contribute to a non-deductible IRA and execute conversions each year, however. Finally, Walden clients should be aware of the pro-rata rule that applies to conversions from a non-deductible IRA. It is assumed that the conversion amount is coming pro-rata from all IRAs (deductible and non-deductible). You are not able to pick and choose which funds are converted, so beware as this has a significant impact on how much tax will be due upon converting.

We cannot overstate the importance of carefully reviewing your situation with a tax advisor beforemaking any decisions regarding a Roth IRA conversion. Numerous factors come into play when analyzing the best course of action, but the benefits may be compelling.

We strongly recommend consulting with your tax advisor prior to making any decisions related to your tax or estate plans.