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Friday, 10 April 2009 19:00 Written by Mary Beth Pavia

2010 marks an impotent year with regard to IRA planning, IRA tax planning and IRA estate planning due to substantial changes to the Roth IRA rules.  The new rules will open the door for more than $1 trillion dollars in potentially convertible retirement plans to a tax strategy that has been limited since it’s development in 1998. 

The option to convert a traditional IRA to a Roth IRA has been around since the development of the Roth IRA over ten years ago. A Roth conversion allows individuals to roll some or their entire qualified retirement plan such as a 401(k) or traditional IRA savings to Roth IRA savings. In effect, the individual will take money that is currently treated as tax-deferred (withdrawals are taxable) and convert it into an account that is forever tax-free, both growth and withdrawals. However, in making this conversion, the individual must pay income tax on the balances converted to a Roth.  While paying this tax may have been inconvenient or even unthinkable in years past, the recent stock market decline may make the option more appealing since the amount converted and so subject to taxes will be lower.  Once converted, future growth in the Roth will forever be tax-free, so converting while the market is so low may be an once-in-a-lifetime opportunity.    

In the past, access to this tax strategy has been limited to households with $100,000 or less of modified adjusted gross income (AGI). However, due to a provision in the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005, the $100,000 income ceiling will be eliminated in 2010, offering higher earners a prime opportunity to roll investments from a Traditional IRA into the Roth IRA.

In addition to the removal of the income provision, there is a special tax incentive for those that convert in 2010. Investors will still have to pay ordinary income taxes on any deductible contributions and investment earnings that are converted from a traditional retirement account into a Roth IRA.  However, if the conversion is made during the 2010 calendar year, federal law allows taxpayers to spread the subsequent tax bill over the following two years, 2011 and 2012, with 50% due each year. 

Rolling your regular IRA into a Roth can achieve the following advantages:

• tax-free growth and withdrawals
• no requirement for minimum distributions at age 70 ½
• potential reduction in estate tax liability
• alleviation of concerns regarding an increase in future tax rates

However, there remain some considerations that need to be made before jumping in and making a potentially costly mistake. The following items need to be reviewed and weighed against the alternatives:

• Have you made any nondeductible contributions to your regular IRA?
• What are your projected income needs? Taking into account the total of all other projected sources of retirement income, will you still need an amount equal to or above your RMD?
• Where will you get the money to pay the taxes? If you don’t have the cash on hand and are considering using funds currently in your IRA to pay the balance, keep in mind that any withdrawal prior to age 59 ½ will be subject to a 10% early withdrawal penalty.
• What are your legacy objectives? Are you concerned with minimizing taxes for your heirs?
• What tax bracket are you in? Is it likely that the Rollover will push you to a higher tax bracket? If so, you could risk disqualifying yourself for otherwise useful tax credits or deductions.
• Are you concerned with where tax rates will be in the future? Do you think you’ll be in a significantly lower tax bracket in retirement?

The above items  need to be considered and reviewed with your Financial Advisor prior to making the decision to convert to a Roth IRA.  If you’re concerned with the tax costs of doing a full conversion, keep in mind that partial conversions are also permissible.  Many people cannot afford to pay the taxes on a full conversion and are under the assumption that this is an “all or none” tax strategy.  Converting only the portion of your account that you can afford to pay taxes on may be a viable option, especially if you can afford to pay the taxes from outside the IRA.  We are happy to consult with clients on a case-by-case basis to evaluate whether such a tax strategy is appropriate for your specific circumstances. Please feel free to contact us with any questions or should you feel that this might be an appropriate strategy to include in your financial plan.

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