The Tax Increase Prevention and Reconciliation Act of 2006 provides plenty of tax breaks for individual taxpayers and business owners alike. One of the biggest of those breaks is scheduled to happen in 2010: being able to convert traditional (both non-deductible and deductible) IRAs into Roth IRAs and pay the taxes over a two-year period. With the proper planning this can help individuals grow their wealth. They will never again pay taxes on this money.
Roth History and Background
Roth IRAs were created by the Taxpayer Relief Act of 1997. After-tax dollars are contributed, allowing individuals to receive tax-free distributions of not only their contributions, but their investment earnings as well, as long as funds remain in the Roth IRA for five years and the owner is at least 59½ years old.
Roth IRAs are different from traditional IRAs in that they have no required minimum distributions (RMD) requirements, so the taxpayer can continue to accumulate wealth in the Roth IRA instead of depleting the assets through RMDs. Roth IRA beneficiaries however, other than spouses, must take tax-free RMDs during their lifetimes. Roth IRAs can be passed tax-free to specified beneficiaries as a part of estate planning. Currently, Roth IRAs are off limits to most high- and middle-income earners. Contributions to Roth IRAs are disallowed when modified adjusted gross income (MAGI) is more than $120,000 for single taxpayers and $176,000 for married taxpayers filing jointly.
Amounts that can be contributed to Roth IRAs are relatively small compared to other retirement plans. For 2009, taxpayers under 50 years of age can contribute $5,000; those over 50 are limited to $6,000.
Roth Conversion for 2009
Traditional IRA owners can complete Roth conversions (rollovers) in 2009. Additionally, other retirement plans, including SIMPLE IRAs (which may trigger early distribution penalties if conversion occurs within two years of contribution). 401(k)s, 403(b)s, and 457 plans can also participate in Roth conversions as long as they are eligible to be rolled over into an IRA. Taxpayers should check with their plan administrators to see if their plans meet eligibility requirements.
Roth conversions in 2009 are still limited by a $100,000 modified adjusted gross income limit, and taxpayers filing as “married filing separate” cannot convert their deferred holdings into a Roth IRA.
The conversion must be completed no later than December 31, 2009. By paying the deferred taxes on the IRA or deferred plan assets, a taxpayer can convert traditional IRAs to Roth IRAs. After five years and after age 59½, withdrawals are completely tax free.
Roth conversions are an especially good planning vehicle for younger people and should be strongly considered. Most likely they will not have a large IRA to convert to a Roth. And, since they are more likely to have modest taxable income, they may be in a low tax bracket, with a lower tax liability. The ensuing tax bill from the conversion would be nominal as well. The payoff would be considerable in the form of tax-free growth and income in future years.
For older taxpayers, the benefits of conversion depend on age and wealth. The conversion to a Roth IRA may be effectively used as a wealth transfer vehicle to the next generation. However, each person’s circumstances are different. So, if taxpayers are at least 50 or older, they should consult a financial planner and tax advisor to determine the best strategy for them.
Conversion Into a Roth IRA
Thanks to the Tax Increase Prevention and Reconciliation Act of 2006, everyone can convert to a Roth IRA in 2010. There is no longer a modified AGI “ceiling” for conversions. This has been permanently repealed. Even married individuals who file separately will be able to convert their IRAs into Roth IRAs. There will still be the same income caps for contributions to Roths, but for taxpayers who do not qualify for contributions there is an easy resolution. Taxpayers can make a non-deductible IRA contribution and then immediately convert the non-deductible IRA into a Roth IRA. The tax consequences would be immaterial with this conversion, because taxes would accrue only on earnings from the one day that the non-deductible IRA existed. Pro-rata rules do apply (to be discussed later).
If taxpayers convert their IRAs to a Roth in 2010, they can take advantage of a favorable provision in the 2006 Act: deferral of the resulting taxes for up to three years. None of the conversion income has to be reported in 2010. Half can be reported in each of the next two years (2011 and 2012) with the last tax payment being made as late as April 2013. After 2010, all conversion income must be reported in the year of conversion. Deferral is not required, however. If it’s more favorable to your tax position, you can elect to have the conversion included in taxable income in the year of the rollover.
Conversion can be beneficial for a variety of reasons. It puts taxpayers in control of the tax liability for their retirement funds by effectively locking in their tax rate at current historically low tax rates. This removes any uncertainty of rising tax rates. They also do not have to take required minimum distributions on Roth IRAs either. So, if the taxpayers do not need IRA distributions for living expenses, they can continue to build up their Roth IRAs and amass wealth for the benefit of future generations or charitable causes.
Partial conversions are allowed, but then the “pro-rata” rule comes into play. All IRAs are taken into account when they are converted. For example, Tom has $400,000 in IRAs, of which $40,000 came from after-tax contributions. Therefore, all Roth IRA conversions will be 90% taxed ($360,000 of pre-tax IRA contributions/$400,000 in total IRA contributions). Now suppose Tom has one IRA totaling $60,000 of which half is from pre-tax dollars and the other half is from post-tax dollars. Upon conversion, Tom will pick up $54,000 (90% of $60,000 account) of taxable income. So, be careful which IRAs are converted first. It is usually better to convert IRAs that have very little after-tax dollars.
Paying the Taxes
It is important that the taxpayer understands that the taxes incurred from the conversion should be paid from other funds. Taking cash out of an IRA to pay the taxes would greatly diminish the benefits, such as tax-free growth, derived from the conversion to the Roth IRA.
Re-characterizing a Conversion
The “undo” button has saved us all, and it is one of the greatest inventions in recent years. The Roth IRA has an undo button as well! A taxpayer can re-characterize any or all of a Roth IRA back to a traditional IRA by October 15 of the subsequent year of the conversion. This can save the taxpayer from a larger than expected tax bill. This strategy works if the market drops after the conversion, and the taxpayer loses market value in the Roth IRA. By re-characterizing back to a traditional IRA, the taxpayer would be entitled to a refund by filing an amended return. After the re-characterization the taxpayer can reconvert back to a Roth IRA and potentially pay a lower tax than originally paid. There is a waiting period, which is defined as the following: “at least 30 days, or until the calendar year after the conversion, whichever is a later date.”
First and foremost, taxpayers should convert their traditional IRAs to separate and new Roth IRAs that do not contain any other Roth IRA funds from prior years. They should also convert to multiple Roth IRAs for each type of asset class in their portfolio. For example, taxpayers should create new and separate Roth IRAs for bonds, equities, international stocks, and other investments. This way the taxpayer will have until October 15th of the subsequent year to pick and choose which Roth IRAs to convert back to a traditional IRA and save on taxes.
From the time a taxpayer converts to a Roth IRA until October 15th of the subsequent year, there is most likely going to be a segment of the market that will go down. Therefore, the re-characterization of “losers” can be made much easier by segmenting the Roth IRAs into different Roth IRA accounts. Once the segments have been re-characterized, all of the winners can be transferred into one large diversified Roth IRA. Taxpayers will also have to amend their tax returns to obtain refunds for amounts overpaid in taxes if they re-characterize their conversions.
When to Convert?
Every taxpayer’s situation is different, and each should consult with a tax advisor and financial planner to determine a strategy best for each situation. Here are some of the reasons that converting in 2009 makes sense:
- The gains and earnings after a conversion will be tax free.
- Tax rates are historically low, and the consensus is that they will rise.
- Converting in 2009 (no matter which date) starts the five-year holding period at January 1, 2009.
The one reason to convert in 2010 is plain and simple: the ability to defer taxes. Conversion income will not become taxable until the 2011 and 2012 tax returns, in some cases deferring taxes another two to three years, while all earnings and gains are tax-free. This opportunity to convert IRAs and other plan assets to Roth IRAs may be a windfall now for the government’s dwindling coffers, but in 30-40 years, most of us will be glad we took advantage of the possibility.
Converting IRAs, or other eligible plans, and doing it right, takes time and patience to complete all of required paperwork. Managing the funds can be time consuming as well. But, in the end, it can be a great wealth preservation tool that will eliminate forever taxes on a piece of your retirement income. It is critical that you work with both your financial planner and your tax advisor to determine whether converting, and perhaps subsequently re-characterizing and then converting again, is beneficial for you.