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"Should You Convert to a Roth IRA in 2010… or After?"

Greensfelder Trusts & Estates Newsletter
Winter 2010

Background

A tax law change on the minds of many clients involves IRAs. Beginning in 2010, there is no longer an income limitation on converting a traditional IRA to a Roth IRA. Converting to a Roth IRA will trigger additional income tax. The amount of the tax is equal to the fair market value of your IRA on the date of conversion less any nondeductible contributions. For conversions made in 2010 only, you can split the income and include half on each of your 2011 and 2012 income tax returns. However, due to the increase in tax rates scheduled for 2011, deferring the payment of these taxes does not make sense for most people.

Distributions from the new Roth IRA will be income tax free, subject to the five year rule described below. By converting to a Roth IRA you are essentially prepaying the income taxes that would otherwise be due when withdrawals are made from the account (withdrawals are required after age 70 1/2, which are referred to as the required minimum distributions (RMDs)).

Benefits of a Conversion

At first glance, whether to convert would seem to be a simple question. If you expect to be in a higher tax bracket in the future, convert to a Roth and prepay the income taxes at the current lower rate. If you expect to be in a lower tax bracket during retirement, stick with the traditional IRA. However, Roth IRAs have two advantages over traditional IRAs that can make it worthwhile to convert even if you expect your tax rates to fall during retirement. First, to the extent you can pay the income taxes on the conversion from taxable assets (not an IRA or other retirement account), then you can shift more wealth to an income tax-free savings vehicle. Second, Roth IRAs do not have RMDs so Roth IRAs can grow income tax-free for a longer time.

Both of these advantages are due to the fact that both traditional and Roth IRAs are income tax exempt vehicles (for traditional IRAs income taxes are only deferred). You do not have to immediately pay income taxes on the earnings (interest, dividends, capital gains, etc.) inside these accounts, so the more money you can accumulate in them and the longer you can keep the money in them, the greater the benefit to you or your family.

The Perfect Situation

The one situation in which it will almost always make sense to convert is if (i) you can pay the income taxes on the conversion from non-retirement account assets, (ii) you will never need to take a distribution from the Roth IRA for living expenses or any other reason, (iii) you are leaving the IRA to individual beneficiaries whom you expect to stretch out distributions over the beneficiary’s life expectancy, and (iv) you have significant enough family wealth that you expect to be paying estate taxes and you do not expect your income tax rate during retirement to decline.

Recharacterizing

The tax laws also allow you to undo a conversion by “recharacterizing” the Roth IRA back to a traditional IRA. A recharacterization must be done by October 15 of the year following the conversion (October 15, 2011 for conversions during calendar year 2010). If the value of your Roth IRA has significantly declined between the date of conversion and the October 15 deadline, it may make sense to recharacterize and then convert again the following year at a lower tax cost (a recharacterization can’t be reconverted in the same tax year as the original conversion and also can’t be reconverted within 30 days of the recharacterization).

Your Age

In general, the younger you are the more likely converting to a Roth IRA will be beneficial, as there will be more time to reap the benefits of tax-free growth inside the Roth IRA. However, if you fall into the “Perfect Situation” category above and will never need to take a distribution from the IRA, then your analysis should be whether the Roth IRA conversion is beneficial to your family (or the beneficiaries of your estate plan). If you convert to a Roth IRA today and pass away tomorrow, there could still be a large benefit to your descendants if they stretch out the distributions over their life expectancies.

Estate Taxes

You may wonder how this analysis changes if you expect to be paying estate taxes. If Congress does not act soon, in 2011 the estate tax exemption will be $1,000,000 per person with a tax rate of 55%. The income taxes paid on converting to a Roth IRA reduces the size of your estate that will be subject to estate tax. If you don’t convert there is an income tax deduction for the estate taxes paid on IRA assets. The beneficiaries of the IRA will use a portion of the deduction each year they take a withdrawal from the IRA until the total deduction is used up. This will offset the double taxation of the IRA, except to the extent there is also a state estate tax (there will be a Missouri and Illinois estate tax beginning again in 2011), as there is no federal deduction for state estate taxes paid. Due to these state estate taxes, you are better off converting to a Roth IRA if you expect to be paying estate taxes.

Five Year Rules

Only distributions of your contributions (not the earnings on the contributions) are tax-free during the five-year period beginning on January 1 of the first year you open any Roth IRA. If your Roth IRA conversion in 2010 is your first Roth IRA, then distributions of “earnings” (interest, dividends, or gain earned after the conversion) will not be tax free until after 2014. If you are under 59 ½ at the time of the distribution, then there will also be a 10% penalty on any distribution during the five year period.

A separate five-year rule applies specifically with respect to a conversion to a Roth IRA. If a distribution is made to you within five years of the year of the conversion, then the 10% penalty will apply even if the distribution is not subject to income tax (i.e. even if you are not distributing any earnings), unless you are over age 59 ½ at the time of the distribution. For example, if you are 50 years old, convert to a Roth IRA, and pay the taxes out of the converted Roth IRA, then you will owe a 10% penalty on the amount used to pay the tax (it is considered a deemed distribution to you). This five year rule applies separately for every year in which a Roth IRA conversion occurs.

Complicated Fact-Sensitive Investment Decision

Deciding whether a Roth IRA conversion makes sense should be made with the joint input of your financial advisor, accountant, and estate planning attorney. However, this is primarily an investment decision. Preferably, your financial advisor can “run the numbers” and forecast the expected advantage or disadvantage to the conversion by making certain spending, tax rate, and other assumptions.

With depressed investment values and low income tax rates, converting to a Roth IRA in 2010 may be a once in a lifetime opportunity. The ability to “undo” it all next year with a recharacterization makes it even more enticing. However, there are significant traps for the unwary in making this decision.

This document offers opinions of an informative nature and should not be considered as legal advice to any specific matter. ©2011 Greensfelder, Hemker & Gale, P.C. All Rights Reserved.