Since their creation in 1997, many taxpayers have been unable to take advantage of Roth IRAs due to income limitations imposed both on direct contributions (in 2009 and 2010, $176,000 for married filers and $120,000 for single filers) and on conversion of traditional IRAs to Roth IRAs (in 2009, $100,000 for both married and single filers). In 2005, the Tax Increase Prevention and Reconciliation Act (TIPRA) made a change that has been dormant since passage, but will have far reaching effects starting next year for taxpayers who were previously foreclosed from utilizing Roth IRAs.
Under the federal tax rules in effect since inception of Roth IRAs, a regular IRA could not be converted to a Roth IRA if a taxpayer's adjusted gross income (AGI) is in excess of $100,000. As a result of the TIPRA of 2005, beginning on January 1, 2010, the AGI limitation on conversion is gone, meaning any taxpayer can convert a regular IRA to a Roth IRA. A converting taxpayer must pay the income tax on the conversion, but may elect to pay the tax in the year of conversion or spread the taxes resulting from conversion over the two years following conversion (i.e., if conversion is made in 2010, the tax payment may be deferred until 2011 and 2012). The tax rate paid on conversion will be the tax rates in effect in the year the taxes are paid.
Once a regular IRA is converted to a Roth IRA, the Roth IRA continues to grow income tax free. Unlike a regular IRA, when a taxpayer reaches age 70½, they do not have to take minimum required distributions out of the Roth IRA, thus allowing the Roth IRA to continue to grow tax-free. Also, when the taxpayer leaves the Roth IRA to their intended beneficiaries at death, those beneficiaries are able to withdraw the Roth IRA over their respective life expectancies tax-free. So, if a 10 year old grandchild is named as the beneficiary, the Roth IRA would be withdrawn over the grandchild’s life expectancy (72.8 years based on the current Single Life Table published by the IRS), and amounts within the Roth IRA continue to appreciate tax-free over that 72.8 year life expectancy.
Generally, there are four factors to consider when a taxpayer is considering converting a regular IRA to a Roth IRA:
- Are income tax rates going up in future years after conversion? Income tax rates now are at a relatively low point in recent history, and with the ambitious programs spelled out by the current administration, it would be logical to expect income tax rates to go up in future years.
- Does the taxpayer have funds outside the IRA to pay the income tax on conversion? By using outside funds, all of the tax deferred (now tax-free) amounts inside the Roth IRA stay intact to continue to grow income tax-free. Be warned that if a taxpayer is under age 59½ and if funds inside the Roth IRA are needed to pay the tax on conversion, they will be subject to an early withdrawal excise tax of 10%.
- Does the taxpayer need the monies inside the IRA to live on after reaching age 70½? If the taxpayer does not need the assets inside the converted Roth IRA to live on, the assets continue their tax-free growth inside the Roth IRA.
- What is the age of the taxpayer? The longer time horizon there is between conversion and when the Roth IRA would need to be paid out at death, the greater the tax-free appreciation.
There are also some estate tax benefits that can be obtained by conversion to a Roth IRA. The payment of the income tax on the IRA conversion out of non-IRA funds gets the funds used to pay the tax out of the taxpayer's taxable estate (income tax rate on taxes paid is lower than the estate tax rate of 45%). Also, it is undesirable to fund a credit shelter trust (sometimes called a “Family Trust”) with a regular IRA due to the income tax liability inherent to the regular IRA. After conversion, the Roth IRA is a much better option for funding a credit shelter trust if other assets are not readily available.
Even after a regular IRA is converted to a Roth IRA, a taxpayer is not locked into keeping the IRA as a Roth IRA. If a taxpayer converts an IRA and the value of the assets decline in value, the taxpayer has until the filing date of their income tax return for the year of conversion to recharacterize the Roth IRA back to a regular IRA and avoid paying the tax resulting from conversion. Therefore, taxpayers have until as late as October 15 of the year following conversion to determine whether to keep the IRA as a Roth IRA and pay the tax on conversion.
Commentators suggest breaking a single IRA into separate IRA's based on asset classes, converting each class to a Roth IRA, and then determining prior to the end of the year of conversion how the assets in the Roth IRAs have performed. The Roth IRAs that have increased in value would be recommended to remain as Roth IRAs (and the tax paid on conversion). The Roth IRAs that have gone down in value would be recharacterized as regular IRAs during 2010 (even though a taxpayer has up to the filing date of their return to recharacterize), which would then allow them to again convert the lower valued IRAs to Roth IRAs in 2011, with the conversion in 2011 being done at the lower value. There is a 30 day “waiting period” on conversion after recharacterizing, so this analysis should be done before Thanksgiving of 2010 to best facilitate the second conversion early in 2011.
If an employee participates in their company’s 401(k) plan, they may ask if they can withdraw their 401(k), roll it over to an IRA, and then convert that IRA to a Roth IRA. An employee who is still in service (i.e., employed) with their company cannot withdraw their 401(k) and roll it over to an IRA if they are under age 59½. But, employees who have reached 59½ would be able to withdraw a 401(k) while still employed, perform a tax-free rollover of the withdrawn funds to an IRA, and then convert the IRA to a Roth IRA.
Finally, for those taxpayers who are Wisconsin residents, a potential issue arises because the law allowing conversion in 2010 for any taxpayer regardless of AGI has not been adopted by the Wisconsin legislature. Therefore, even if the conversion would be allowed for federal income tax purposes, the conversion may have negative Wisconsin income tax effects. It is widely believed by noted commentators that the Wisconsin legislature will correct this problem in 2010, but this should be a consideration taken into account by Wisconsin residents before converting.
The decision to convert regular IRAs to Roth IRAs should be made by taxpayers in conjunction with their accountant, IRA provider and estate planning attorney. If you have questions or would like assistance with the decision to convert beginning in 2010, please contact the author of this update or one of Michael Best’s Wealth Planning attorneys.