2010 Roth IRA Conversions
November, 2009
Under current tax law, individuals may convert a traditional IRA to a Roth IRA without incurring the ten percent early withdrawal penalty. A Roth IRA conversion occurs when a taxpayer distributes assets from a traditional IRA and rolls them directly into a Roth IRA.
However, not everyone who wants to convert a traditional IRA to a Roth IRA is permitted to do so. Under current law, there is an existing income limit which determines eligibility to convert. Taxpayers, including married couples filing jointly, with an adjusted gross income exceeding $100,000 are prohibited from converting their traditional IRA to a Roth IRA.
On May 17, 2006, President Bush signed the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005 into law. This tax bill included a provision dealing with conversions of traditional IRAs to Roth IRAs. Effective for taxable years beginning after December 31, 2009, TIPRA amended the Internal Revenue Code to eliminate income limits on conversions of traditional IRAs to Roth IRAs. As a result, beginning January 1, 2010, any taxpayer who wants to convert his or her traditional IRA to a Roth IRA may do so.
IRA vs Roth IRA
The assets held by both a traditional IRA and a Roth IRA grow tax free. However, where a traditional IRA is a retirement plan that is tax deferred until withdrawal, a Roth IRA is a retirement plan that allows contributions to be taxed up front.
Roth IRAs are a popular retirement savings vehicle because unlike a traditional IRA there is no "minimum required distribution" requirement during the owner's lifetime. Additionally, qualified distributions from a Roth IRA, including contributions and investment earnings, are tax free at the federal level. This allows plan assets to continue growing and be passed on to the owner's beneficiary tax free.
To be eligible to make a participant contribution to a Roth IRA, the taxpayer must have a modified adjusted gross income (MAGI) that does not exceed a certain amount, depending on the taxpayer's tax-filing status. For example, in 2009, a taxpayer's contributions to a Roth IRA begin to phase out if their MAGI exceeds $105,000 ($166,000 for joint filers). Contributions are completely phased out for taxpayers whose MAGI is more than $120,000 ($176,000 for joint filers).
Historically, the $100,000 income limit on conversions as well as the contribution limitations have precluded upper income taxpayers from enjoying the benefits that Roth IRAs have to offer.
401(k) and other accounts eligible for conversion to Roth IRA
Prior to 2008, a taxpayer could only convert funds from a traditional IRA into a Roth IRA. This meant funds in an employer qualified plan first had to be rolled over from the qualified plan into a traditional IRA before conversion to a Roth IRA. However, as of 2008, taxpayers can convert funds into a Roth IRA directly from their employer's qualified plan including a 401(k) plan. Additionally, distributions from tax-sheltered annuity plans as well as governmental plans can be rolled over to a Roth IRA.
Planning Opportunity
The repeal of the income limitations associated with IRA conversions presents a great planning opportunity for those individuals with significant funds in a traditional IRA and the financial means to pay taxes associated with the conversion. Beginning on January 1, 2010, anyone will be able to convert a traditional IRA to a Roth IRA regardless of income level. Eliminating the Roth IRA conversion limit does not mean anyone can contribute to a Roth IRA since the contribution limitations still apply. However, it does provide the attractive opportunity to convert an existing traditional IRA to a Roth IRA.
As an additional bonus, under the new law, if a taxpayer makes a conversion in 2010 no resulting income will be reported on an individual's federal income tax return for 2010. More specifically, unless an election is made, that taxpayer will report half the income from the conversion in 2011 and the other half in 2012. However, income inclusion is accelerated if the converted amounts are withdrawn before 2012.
While tax deferral is typically advantageous, if taxes are paid in 2011 and 2012, the taxpayer is subject to the effective tax rates for 2011 and 2012. Since 2010 is the last year for the current income tax rates before they sunset in 2011, it may be advantageous to pay tax in 2010 given the historically low rates. Conversions in later years are includible in income in the tax year in which the conversion occurs.
For certain taxpayers, a Roth conversion can create a very attractive basis for leaving a legacy for intended beneficiaries because the intended beneficiaries will continue to benefit from the tax-free growth of the account. As one example, an individual or a couple who do not expect to rely upon their qualified retirement accounts or some portion of them for income during retirement are well poised to take advantage of this opportunity. After the conversion, the Roth IRA will continue to grow without taxation until it is transferred by the owner to his or her intended beneficiary as part of their estate plan.
Undertaking a Roth conversion of an existing retirement account is a significant decision and requires consideration of various factors. If you are interested in learning more about whether converting a traditional IRA to a Roth IRA is right for you please contact the Tax Group at Bullivant Houser Bailey.
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