Starting in 2010, all taxpayers will be eligible to convert a regular IRA to a Roth IRA, regardless of their level of adjusted gross income ("AGI"). The option opens new opportunities, but also may require important tax planning.
CURRENT CONVERSION RULES
Under the current law, a taxpayer (other than a married person filing separately) can convert all or part of a regular or SEP IRA to a Roth IRA if the taxpayer's AGI is $100,000 or less. A SIMPLE IRA may also be converted if the taxpayer has participated in the SIMPLE IRA for at least two years. A conversion requires the value of the IRA to be taken into income, but the 10% early withdrawal penalty for payments prior to age 59½ will not apply.
CHANGES IN 2010
The $100,000 AGI eligibility limit has been eliminated which opens the conversion opportunity to any taxpayer who has a regular IRA. The question is whether a taxpayer should convert, and if he converts in 2010, should the taxpayer take advantage of the new opportunity to pay the tax in 2011 and 2012?
WHY CONSIDER A CONVERSION?
First, distributions from a regular IRA are taxable as ordinary income. Distributions of both the contributions and the earnings from a Roth IRA are tax-free, so long as they are "qualified distributions." To be a "qualified distribution" the Roth IRA must have been held for at least 5 years and the distribution must be received after age 59½ (or on account of death or disability).
Second, regular IRA distributions must begin no later than the year following the year the taxpayer attains age 70½. Roth IRAs are not subject to these rules. This means the Roth IRA can be held after age 70½, and until death, without any required distributions (beneficiaries of a Roth IRA are subject to required distribution rules). The Roth IRA, therefore, allows a pass-through of tax-free income to the taxpayer's heirs.
Other advantages of the tax-free payments from a Roth IRA include keeping a taxpayer in a lower tax bracket than would otherwise apply if taxable distributions were received from a regular IRA; tax-free Roth IRA distributions will not enter into the calculation of tax owed on Social Security benefits; and tax-free Roth IRA distributions will not affect AGI-based itemized tax deductions which otherwise are phased out based on the taxpayer's AGI.
WHO SHOULD CONVERT?
Although there are always exceptions, it is generally thought that conversion should be considered by taxpayers who:
Can afford to pay the taxes resulting from a conversion by using other assets.
Have a number of years to go before retirement, so they are able to regenerate the funds used to pay taxes on the conversion.
Believe they will be in a higher tax bracket in later life than their current tax bracket.
Do not contemplate needing the funds in the IRA for retirement expenses, so the Roth account can be held tax-free and passed to the taxpayer's heirs. If this is the case, it should also be noted that paying the income tax from other assets on conversion to the Roth IRA will also reduce the taxable estate for estate tax purposes.
Lost a great deal of value in the stock market in 2007 and 2008 and have not had their account balance recover. With the lower value of the regular IRA, now might be an ideal time to pay lower taxes on the current value, convert to a Roth IRA, and enjoy the recovery in the tax-free Roth.
IF YOU CONVERT IN 2010, WHEN SHOULD YOU PAY THE TAX?
The reason Congress repealed the $100,000 eligibility limit for conversion was to encourage higher income taxpayers to convert to a Roth IRA, and thereby pay taxes on their regular IRA now rather than in future years. To further encourage the conversion, Congress gave taxpayers two years to pay the taxes due (2011 and 2012).
Will it make sense to defer the income tax from 2010 to 2011 and 2012? Given the real possibility of increased tax rates for higher income taxpayers beginning in 2011, a prudent decision might be to pay the entire tax bill generated by conversion to a Roth IRA in 2010 rather than pay the taxes in 2011 and 2012.
ROTH IRA CONTRIBUTIONS
The contribution rules for a Roth IRA have not been changed. Therefore, new contributions may not be made to the Roth IRA if the taxpayer's AGI exceeds the eligibility limit. In 2009, the eligibility limit is AGI of $120,000 for single taxpayers and $176,000 for married taxpayers filing jointly.
This article is an abridged version of an earlier article that appeared in the Human Resources Newsletter which is available at our Web site, wnj.com. If you would like to discuss a Roth conversion, please contact your WN&J attorney.