Roth IRA Changes: As Good as Good News May Get in 2010By Herb Johnson, CPA
Article Date: 03-01-2010
Copyright(C) 2010 Associated Equipment Distributors. All Rights Reserved.
Beginning this year, converting from traditional IRA holds numerous advantages for high-income individuals, including the unexpected benefit of estate planning.
High-income and high-net-worth individuals who may have waited for years to convert a traditional IRA to a Roth IRA will finally get their chance in 2010. That’s when the income limits that prevented some traditional IRA owners from making the conversion, will be lifted.
The benefits of the Roth IRA will be available to thousands more individuals, whether they are seeking to amass retirement income, minimize taxes in retirement, or pass wealth on to heirs with minimal tax obligations. Of course, every individual situation is different, and it is impossible to make general statements about any particular investment strategy. This article is not intended to replace an in-depth, personalized discussion with tax and personal financial planning advisors.
Background and Development
Individual Retirement Accounts (IRAs) have been around for more than three decades. The earliest version of these tax-advantaged accounts was made possible beginning in 1975. A traditional IRA is an individual retirement account or an individual retirement annuity, but does not include a Roth IRA. The Roth IRA did not come into being until 1998. Almost immediately, retirement investors saw the benefits of the new Roth IRA, and began converting their traditional IRAs to the newer version. It wasn’t long before Roth 401(k), Roth 403(b) and Roth 457(b) were also introduced, with higher employee contribution limits, plus the advantages of employer sponsorship.
Beginning in 2008, amounts in regular 401(a) (which includes a 401(k)), 403(b) and governmental 457(b) plans were allowed to be rolled over directly into a Roth IRA (with income limitations). This often happens when an employee terminates employment.
The most recent developments in IRAs stem from the Tax Increase Prevention and Reconciliation Act of 2005, which eliminates the income limits for converting a traditional IRA to a Roth IRA in 2010, and provides other benefits to encourage the switch.
Thousands are expected to take advantage of this opportunity.
According to the Employee Benefit Research Institute, total IRA assets in 2007 stood at $4.65 trillion. Rollover IRAs (assets accumulated in some other account, such as a 401(k), then moved to an IRA) accounted for 47 percent of total IRA assets. Traditional IRAs accounted for 44 percent of the total, and Roth IRAs, 8.3 percent.
Throughout the development of IRAs, investors have sought:
The greatest tax advantage, whether at the time of contribution or the time of withdrawal
Maximum contribution limits (or no limits at all)
Minimal limitations based on income, age and
Flexibility to change the investment based on age, personal financial situation, market and economic
conditions, and new regulations
Traditional IRAs verses ROTH IRAs
Traditional IRAs generally appeal to investors looking for a current-year tax deduction and tax-deferred earnings. Roth IRAs, on the other hand, do not offer a current tax deduction, but they grow tax-free, and distributions are generally tax free. Some investors have found that the benefits of a traditional IRA lose some of their appeal as income rises, leading to the desire to convert to a Roth IRA. Choosing between these options requires an understanding of the similarities and differences between them.
Contributions are deductible (with income limits)
Nondeductible contributions are allowed
Withdrawals are required at age 70 ½
Withdrawals at retirement are taxable (prior nondeductible contributions will reduce the taxable amount)
Early withdrawals from contributions or earnings are taxed and penalized
The chart at the top of this page compares some of the basic features of both types of IRAs.
Contributions are not deductible
Withdrawals by owners are not required at any age
Withdrawals by beneficiaries are not required
Withdrawals at retirement from contributions or earnings are tax-free
Early withdrawals from contributions are tax-free, but from earnings they are taxable and a penalty is assessed
In the very simplest terms, a traditional IRA will produce the same after-tax result as a Roth IRA, provided that:
If the end result is the same, why favor a Roth IRA over a traditional IRA?
The annual growth rates are the same
The tax rate in the conversion year is the same as the tax rate in the withdrawal years
If the Roth IRA owner does not need funds for living expenses, there is no mandatory distribution requirement, even at age 70 ½. Roth IRA owners need never make any withdrawals, allowing the assets to pass to heirs.
If withdrawals are made five years after a Roth IRA is established, and the account owner is 59 ½-years-old, those withdrawals can be made tax-free.
Traditional IRA to Roth IRA Conversion
A Roth conversion is a transfer of funds from a traditional IRA or a qualified plan (such as an employer-sponsored 401(k)) to a Roth IRA. The conversion may be made through a direct trustee-to-trustee transfer, or by a distribution from the traditional IRA or qualified plan that is rolled over to a Roth IRA within 60 days.
Before 2010, if an investor had funds in a traditional IRA, those funds could be converted to a Roth IRA only if the investor’s modified adjusted gross income (MAGI) was less than $100,000. If the MAGI was over that limit, the conversion option was not available.
This restriction has been frustrating for high-income individuals, because they could not take full advantage of the potentially significant tax benefits of a Roth conversion. One of those benefits shows up at retirement, when withdrawals from a Roth IRA typically will be tax-free.
With a traditional IRA, certain taxpayers (depending on income) can make deductible contributions now, but must pay income tax on withdrawals at retirement. Thanks to the Tax Increase Prevention and Reconciliation Act of 2005, the income limits for a Roth conversion are lifted beginning in 2010. Anyone, regardless of income, will be able to convert traditional IRAs to Roth IRAs starting in 2010.
Converting to a Roth IRA does have tax consequences that are determined by whether or not funds are:
Previously deductible amounts that reduced taxable income when contributed to the traditional IRA –
these amounts will be taxable
Contributions to a traditional IRA that were nondeductible contributions and will not be taxed as income when withdrawn
Earnings on deductible and nondeductible contributions, which will be taxable
Pay Taxes Now, or Later
In 2010, there is another tax advantage. When a traditional IRA is converted to a Roth IRA under normal circumstances, the taxpayer owes income tax in the current tax year on the converted taxable amount. But that won’t be the case when the conversion is made in 2010.
Under the new law, the taxpayer can elect to report all of the income in 2010, or the income can be divided evenly and reported in 2011 and 2012. This option to spread the tax liability over two years can be especially attractive to those who expect high income in 2010, but who may be able to control their adjusted gross income (AGI) to lower it (relatively speaking) in 2011 and 2012. Beginning with 2011 conversions, the entire conversion amount will be reported in the year of the conversion.
The primary benefit of a Roth IRA conversion is that all earnings from a Roth IRA are completely tax-free if distributions are made after a five-year holding period and the taxpayer is 59 ½ or older. Distributions from a traditional IRA are fully taxable at any age (with the exception of distribution of nondeductible contributions) at the taxpayer’s current tax rate.
Not all states have recognized Roth contributions or conversions. Consult a local tax advisor to determine your eligibility to recognize these benefits on state tax returns.
Good Candidates for Conversion
Traditional IRA to Roth IRA conversion is not for everyone. Every investor will want to talk to a tax professional and/or financial planner before making any commitments. However, in general terms, good candidates might include:
Persons who think they will not need their IRAs to supplement their retirement income
Persons who will always be in the highest tax brackets
Persons who have sufficient cash or high basis assets (that would be liquidated) to pay the income tax
due on the conversion
Persons who want to leave money to heirs
Persons whose estate will likely be subject to federal estate tax
Young people who are still early in their work career who can benefit from many years of tax-deferred growth, especially if they are currently in the lower tax brackets
Persons who believe that income tax rates will be higher in the future
Roth IRAs offer the unique opportunity to “recharacterize,” or reverse a previous conversion. For example, there may be a substantial decline in the value of Roth IRA investments after a conversion, and the investor does not want to pay taxes on the converted amount. Or maybe the investor just decides he or she no longer wants to pay the tax owed on the conversion.
Up until Oct. 15 of the year after the conversion, the owner can recharacterize part or all of the Roth IRA conversion to move funds back to a traditional IRA. Subject to a waiting period, the owner can choose to later reconvert the traditional IRA to a Roth IRA. This can go on indefinitely, year after year, to gain the most favorable markets and minimize taxes.
Other Roth IRA strategies include:
If income is less than $100,000 – With the market currently recovering from record lows, the account values of many traditional IRAs may be suffering. If a conversion were made in 2009, the income tax due at the time of conversion might be less than if the conversion was made in 2010, when investors are hoping for a market recovery.
Investor is not covered by a qualified retirement plan – Individuals in 2009 with income over $105,000 ($166,000 for those filing joint returns) would not normally be able to contribute to a Roth IRA. Regardless of whether they are a participant in a qualified retirement plan, they are eligible to make a contribution to a traditional IRA in 2010. Then, in 2010, that traditional IRA could be converted to a Roth IRA.
The 401(k) “protector” – This strategy is for someone with both deductible and nondeductible IRA account balances, and a 401(k) plan that accepts rollover contributions. With a partial conversion, tax would be due on the pro-rated portion of both IRAs. To avoid this, it may be possible to roll an IRA into a 401(k) plan so that the nondeductible traditional IRA contributions would be used in the conversion to the Roth IRA, thus reducing the 2010-related tax burden.
Roth IRAs and Your Estate
Although it was probably never intended to be used as such, the Roth IRA can be a tool for estate planning. Unlike a traditional IRA, a Roth IRA account owner is not required to take minimum distributions, even at age 70½. This simply means that the funds can be left in the account, and upon the death of the account owner, inherited by someone else.
For example: You are age 70 and have a traditional IRA, which you convert to a Roth IRA. The Roth IRA is worth $1 million and you are currently in the 35 percent federal tax bracket. In the next 15 years, the Roth IRA grows at a 6 percent rate. You are not required to take minimum distributions. The Roth IRA stands at roughly $2.4 million when your oldest daughter inherits it at age 50. Your daughter can now make withdrawals of approximately $174,000 per year, tax free, for the next 30 years.
The cost to you, the original IRA owner, for leaving this legacy was $350,000 in federal income tax, which will be spread over the 2011 and 2012 tax years, unless you elect to pick up the income in 2010.
Of course, this scenario assumes that tax laws will remain unchanged and that you will not need the money in the Roth IRA during your lifetime.
For many IRA investors, 2010 will offer opportunities to maximize the long-term value of their investments, especially for individuals with high income and assets available to pay income tax generated by a traditional IRA to Roth IRA conversion.
The ability to recharacterize a Roth IRA conversion also offers tremendous flexibility to respond to market and tax law changes. In every case, investors should examine their unique financial situation to determine if the advantages of a Roth IRA conversion outweigh the disadvantages.
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