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The Roth IRA: To Convert or Not to Convert
– March 9, 2010
Responding to widespread demand for better access to Roth IRAs, the federal government is lifting some restrictions on them and giving a tax break to those who choose to convert a conventional IRA to a Roth IRA in 2010. The changes have some advisors preaching the virtues of these retirement accounts and urging their clients to take advantage of this "once-in-a-lifetime opportunity." However, the conversion decision is far more complex than it might appear and may be less attractive than you think. What is this all about? Here are some of the answers for the millions of Americans with IRAs.
What's a Roth IRA?
A Roth IRA is a tax sheltered retirement account. A traditional IRA gives you upfront tax deductions for the money you contribute but levies tax on every dollar in the account, including principal and investment returns, when you withdraw the money at retirement. In contrast, a Roth IRA provides no upfront tax deductions for your contributions but promises that every dollar pulled out of the account when you retire is tax-free. That's attractive to those who expect to be wealthier or expect tax rates to be higher when they're retired.
Do you have to take Required Minimum Distributions?
With a traditional IRA you have to start taking taxable distributions upon the age of 70 ½. With a Roth IRA, you don't have to take any distributions and you can leave your heirs the entire account balance, assuming you don't need the money during retirement.
Why Convert Now?
Roth IRAs are attractive to many groups including people who are currently in low tax brackets, taxpayers who have tax attributes such as net operating losses, and high-income taxpayers who have been put on notice that the current administration plans to raise tax rates on the rich. But high-income taxpayers have been largely locked out of Roth IRAs because the IRS won't let them contribute to one if they earn more than $120,000 if single or $176,000 if married. In the past, taxpayers who wanted to convert a traditional IRA to a Roth IRA were blocked if their adjusted gross income exceeded $100,000. The income restrictions on people wanting to make new contributions to a Roth IRA remain in effect. But starting in 2010, anyone can convert a traditional IRA to a Roth IRA, regardless of income. Additionally, those who convert in 2010 will have the option to pay all the income tax that a conversion creates in 2010 or, by default, the IRS assumes that you would like to defer the tax to the 2011 and 2012 tax years.
What are the income tax implications?
You essentially have to withdraw funds from your traditional IRA and recognize the distribution as income before re-depositing those same funds into a Roth IRA. The conversion income can sometimes push you into a higher tax bracket, which can make conversion costly. However, for 2010 only, relief is available for conversion. If you convert your traditional IRA to a Roth IRA this year, you can split the income generated by the conversion and apply half to 2011 and half to 2012. That means you would delay paying the income tax on the deal for up to two years.
Should you defer the taxes?
The deal may sound better than it is in reality. Normally, deferring income is a good thing, but there is always an exception. If you are a high-income taxpayer, as are most of the people who are newly allowed to convert, you're likely to face higher income tax rates in 2011 and 2012 than you do now because of tax increases that Congress is planning. If you wait until 2011 or 2012, which the government assumes unless you elect otherwise, you're likely to pay more tax on this income than you would have if you paid the tax in 2010. The IRS assumes you will make the choice that generates the most tax paid to the government.
Should you convert?
That is the question of the hour. It is difficult to work out the math on this because you have to make several assumptions. For a conversion to make sense, you have to assume four things:
- That you'll pay the tax obligation created by the conversion in cash, not by draining your IRA assets.
- That you'll have many years to accumulate tax-free earnings before you'll ever access the account
- That you'll pay higher tax rates in the future than you do now.
- That Congress will not renege on the promise to never tax Roth IRA assets.
Even then, there may be situations in which the conversion doesn't make sense. Your tax and investment advisors can help you decide which choice would land you the most retirement money in the end. However, there are so many unpredictable factors involved in the decision that it's difficult to predict the future.
Are there any strategies that can be used to minimize the tax?
Absolutely. One strategy includes converting your traditional IRA into several Roth IRAs based on the various asset classes of your investments. Should one asset class suffer a decline in value, you are able to re-characterize that account back to a traditional IRA by October 15th of the year following the conversion. If the tax has already been paid, a full refund with interest is available by filing an amended return. The taxpayer may then "reconvert" the remaining account balance to a new Roth IRA and begin the process over again. Re-characterizations are unlimited in number. This strategy allows the taxpayer to look back with perfect hindsight to insure that they recognize the smallest amount of taxable income upon conversion. Various other strategies are also available to take advantage of the re-characterization rule. Careful planning with both your tax and investment advisors can result in significant tax savings.
Conclusion
Choosing whether or not to convert may be a complex and uncertain decision. However, with careful analysis and realistic assumptions, a rational decision can be made for any scenario. As always, we recommend that you consult with your trusted advisors to analyze your specific situation before making your final decision regarding Roth IRA conversion.
Please contact Michael Fulco for a comprehensive analysis to determine if a Roth IRA conversion is right for you.
Michael Fulco
318.429.2107
mfulco@hmvcpa.com
Michael is a member of the tax and business valuation departments in our Shreveport location. He received a Bachelor of Business Administration degree from the University of Louisiana at Monroe and went on to receive a MBA from Louisiana State University in Shreveport.