Why should I consider converting my Traditional IRA to a Roth IRA in 2010?
As 2010 approaches, many people will position themselves to take advantage of the Roth IRA conversion strategy in order to avoid taxes. Normally, there is a $100,000 income limit on the ability to convert from a traditional IRA to a Roth IRA. However, in 2010, the limitation on income is lifted. Moreover, tax payments that are due on the conversion in 2010 may be spread out over 2011 and 2012, rather than paid entirely in the year of distribution. This may represent your silver lining in the cloud resulting from declines in the stock market.
1. What is a Roth IRA?
2. What are the advantages of a Roth IRA?
3. How do Roth IRAs differ from traditional IRAs?
4. What is "conversion" of a traditional IRA to a Roth IRA?
5. Am I eligible to convert my traditional IRA to a Roth IRA?
6. What are the tax consequences to converting?
7. What disadvantages do Roth IRAs have?
8. What should I consider before making a decision to convert?
9. Can I undo my Roth conversion?
10. A Note of Caution
1. What is a Roth IRA?
A Roth IRA is an Individual Retirement Account allowed under U.S. law. Unlike traditional IRAs, you must use after tax money to contribute to a Roth IRA. But in return for that, you never pay income tax on the income from your Roth investments, even when you take money out during retirement. Traditional IRAs, on the other hand, have relatively low contribution limits and tax on the income you earn is deferred until you actually take it out of the account.
2. What are the advantages of a Roth IRA?
Advantages of Roth IRAs over regular IRAs include the following:
- Earnings accumulate income tax free, i.e., principal and earning within the Roth IRA are not subject to income taxes.
- You need not take "required minimum distributions" during your life and, thus, more earnings can accrue during your life.
- Your Roth IRA can be passed to your spouse and beneficiaries. While a non-spousal beneficiary must start required minimum distributions, the payout can be stretched over the beneficiary's life expectancy. If you plan on passing the money in your IRA forward to your heirs, take your heirs' tax rates into consideration before doing the conversion.
- All withdrawals from a Roth IRA five (5) years after the conversion are tax-free.
- All withdrawals are penalty free any time.
- The size of your estate will be reduced for federal estate tax purposes.
3. How do Roth IRAs differ from traditional IRAs?
The biggest difference is that unlike traditional IRAs, there is no upfront tax break for making contributions to a Roth IRA. But, distributions of principal and earnings on your contributions will not be taxed in the future.
4. What is "conversion" of a traditional IRA to a Roth IRA?
“Conversion” is usually accomplished by rolling over a distribution from a traditional IRA to a Roth within sixty (60) days of the distribution. You will be taxed on the distribution from the traditional IRA. In effect, the distribution is followed by contribution of the distributed amount to the Roth account. Income tax is assessed based on the traditional IRA's value on the conversion date. Until 2010, taxes are payable in the year of conversion. In a conversion in 2010, however, the tax may be spread between 2011 and 2012.
5. Am I eligible to convert my traditional IRA to a Roth IRA?
You can convert if your filing status is single or married filing jointly. If you are married but filing separately, you will not be eligible to convert your traditional IRA to a Roth IRA.
Not all traditional IRAs can be converted to Roth IRAs. For example, inherited IRAs cannot be converted. Through 2009, in order to convert, your adjusted gross income cannot exceed $100,000. This rule is eliminated in 2010.
6. What are the tax consequences to converting?
When converting your traditional IRA to a Roth IRA you must include in your income the amount of the entire distribution from the traditional IRA, but then you enjoy the favorable tax treatment afforded by Roth IRAs. There is no limit on the amount that can be converted. Partial or total conversions are fine. There is no limit on the number of times an individual can convert a traditional IRA to a Roth IRA with one exception: you cannot convert a traditional IRA to a Roth IRA and then "unconvert" in the same year. For more information regarding "unconverting" or undoing your conversion, see Question 9 below. In tax years before 2010, the entire distribution amount must be included in income. However, if you convert in 2010, you can elect to spread taxes due over two years, such that in 2010 there is no tax and you would pay the taxes equally in 2011 and 2012. Further, there is no 10% penalty on the amount converted.
If you converted your traditional IRA into a Roth IRA in 2008 before the stock market freefall, your Roth IRA is now worth considerably less than it was on the conversion date and you paid 2008 income taxes on "phantom value" that no longer exists. The good news is that you can reverse the conversion until October 15, 2010, as explained in Question 9.
7. What disadvantages do Roth IRAs have?
Converting to a Roth requires you to pay taxes up front and receive tax-free distributions later. The usual notion is that it is preferable to defer taxes until death where however, if you believe income tax rates will rise in the future above the current low rates, you may find it advantageous to pay the taxes up front.
- Contributions to a Roth IRA are not tax deductible.
- You may be taxed on high values today, if the value of your account declines in future years.
- Future income tax rates may be lower.
- Deferring tax using a traditional IRA reduces adjusted gross income. Not true for a Roth IRA.
- Conversion may trigger the alternative minimum tax even if your adjusted gross income is less than $100,000 per year. You can plan around this by delaying part of the conversion to the following year.
- If you don't live to retirement or much beyond retirement, the tax structure of a Roth will only reduce an estate that may not be subject to tax.
- Congress may change the rules that currently allow for tax-free withdrawals of Roth IRA contributions.
8. What should you consider before making a decision to convert?
You may benefit from converting your traditional IRA to a Roth IRA if the following apply to you:
- Your life expectancy is long and above average.
- You can afford to pay the income taxes due on conversion from other assets.
- Your portfolio value is down, so you will pay less tax than you would have previously.
- You do not need to draw down the Roth IRA during your lifetime because you have sufficient other income.
- Your designated beneficiaries are young which will minimize tax-free growth.
- If you are under 70 ½ and retired with a large IRA, conversion to a Roth IRA will eliminate the need to take future required minimum distributions.
- You believe income tax rates will go up in the near future.
- If are 70 ½ and in a higher tax bracket, you may consider partial conversion of your traditional IRA to a Roth IRA over years. This allows for future distributions for Roth IRA to be tax-free and allows greater Roth plan asset accumulation.
9. Can I “undo” or “unconvert” my Roth conversion?
You can "undo" or “unconvert” your Roth IRA back to a traditional IRA, and if you do so correctly, it will appear that the conversion never happened. You need to fill out and submit the proper forms to your Roth IRA custodian and to the IRS. You may also have to amend your tax form.
Let's assume you converted your traditional IRA to a Roth IRA in early 2008 before stock market declined significantly. Here is the methodology: Your IRA custodian should have reported to you and the IRS the deemed distribution resulting from the conversion on 2008 Form 1099-R. If you haven't filed your 2008 tax return yet, enter the amount from Form 1099-R on line 15(a) of your 2008 IRS Form 1040. Then enter the taxable amount of $0 on line 15B. If you have already filed 2008 taxes, file an amended return (IRS Form 1040X) to show the reversal and collect your rightful tax refund. On line 1 of the 1040X, subtract the amount of taxable income that is triggered by the now reversed conversion and calculate the reduced 2008 tax bill on lines 6-10. Explain (on page 2 of the 1040X) that the changes are due to reversing your 2008 conversion.
10. A Note of Caution
There is no guarantee that conversions will still be available next year. Congress could eliminate the provision; a general increase in income tax rates could make the conversion less attractive; or Congress could create a new tax on Roth accounts (which would be a disaster, since you would have paid taxes twice).
If you are eligible to convert to a Roth IRA in 2010, it is worth talking to a professional to make sure that adding to your income does not have unintended consequences. Run the numbers. Roth IRA conversion is a good idea for many. If you wait until the market recovers, you may miss out on an opportunity to reduce your taxes.
This general legal information should not be treated as tax, legal or accounting advice. Every situation is different and other issues may exist. Nor should this information be used as a guide in all situations. Please contact attorneys Marisa Petrella or Linda Hagan at mail@petrellabrown.com for additional information.