Seizing Opportunity and Converting to a Roth IRA

Converting your traditional IRA to a Roth IRA is a once-in-a-generation opportunity to transfer wealth

Tax year 2010 brings a significant opportunity for many taxpayers. Beginning this year, taxpayers will be able to convert their traditional IRA to a Roth IRA, regardless of their income level or filing status. Furthermore, tax on the taxable income resulting from a 2010 conversion can be deferred until 2011 and 2012. The ability for high-income taxpayers to convert traditional IRAs to Roth IRAs presents tax and retirement planning opportunities.

Prior to 2010, only individuals with modified adjusted gross incomes (AGI) of $100,000 or less could convert amounts in their traditional IRAs to Roth IRAs. Moreover, married taxpayers filing separate returns were prohibited from converting. Starting in 2010, the $100,000 AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated completely. This new rule gives everyone the opportunity to convert a traditional IRA to a Roth IRA.

Be aware that an IRA conversion is treated as a taxable distribution, taxed as ordinary income at your marginal tax rate. This in effect accelerates the taxable income that you would eventually pay on distributions from a traditional IRA once you retire, but does so in exchange for never having to pay tax on any future appreciation in the value of your account from what it is today. That is often a significant tax advantage. Note that unlike a withdrawal from an IRA, a conversion does not trigger the 10% Federal and 2.5% California early withdrawal penalties.

“Beginning this year, taxpayers will be able to convert their traditional IRA to a Roth IRA, regardless of their income level or filing status.”

Although conversion to a Roth IRA triggers immediate taxable income, lawmakers have provided a special incentive in 2010 to encourage Roth conversions under the new rules. In 2010 (and 2010 only), taxpayers will have the choice of recognizing their conversion income in 2010 or spreading it evenly between 2011 and 2012. This allows you to pay taxes on the converted amount ratably over two years, instead of recognizing it all as income in one year. However, if you choose to pay tax in 2011 and 2012, you will be taxed on the rates that apply for those years, which are expected to be higher than the rates for 2010, at least for the top two tax brackets.

Taxpayers are expected to convert their traditional IRAs to Roth IRAs for a variety of reasons. Roth IRAs have two major advantages over traditional IRAs:  

  • Distributions from Roth IRAs are tax-free if they are qualified distributions. To be qualified, they must be made after a five-year holding period has passed and after the account holder reaches age 59 1/2, or on account of death, disability, or the qualified purchase of a first home.
  • Roth IRAs are not subject to the required minimum distribution (RMD) rules that apply to traditional IRAs (as well as individual qualified plans). Therefore, a Roth IRA account holder who reaches age 70 1/2 does not need to begin taking distributions; instead, the funds can continue to grow tax free until they are needed or are passed on to heirs.

The tax-free nature of qualified Roth IRA distributions may prevent individuals from being taxed in a higher tax bracket that would otherwise apply if they were withdrawing taxable distributions from a traditional IRA. Moreover, these distributions–unlike those from traditional IRAs–do not effect the calculation of tax owed on Social Security benefits and do not affect AGI-based deductions, such as medical expenses or charitable contributions.

A traditional IRA to Roth IRA conversion should be considered by individuals who:  

  • Can pay the tax on the converted amounts from non-IRA assets;
  • Do not anticipate being in a lower tax bracket in the future than they are currently in; and
  • Have a significant amount of time before reaching retirement to allow assets to grow tax-free and recoup taxes paid due to the conversion;
  • Will have either very little taxable income or a taxable loss in 2010.

Financial advisor Brian Oard with BNY/Mellon Wealth Management in Century City says, “No one likes the idea of recognizing losses, but there are ways to minimize the pain and reposition your balance sheet for the future. Conversion of IRA assets to a Roth IRA represents one of these opportunities. But given the complex tax and legal issues, most investors need expert advice to come up with the right solution.

“One family, who sold their rental property at a loss, was able to use that loss creatively. By converting all of their Traditional IRA assets into a Roth IRA, they were able to offset taxes they would have owed on the conversion with the loss on the sale of their property. Furthermore, the Roth IRA will now grow tax deferred and come out tax free when the family needs the assets.

“Another couple in their late 60’s are winding down and closing out a retail store that has suffered greatly in the downturn. We worked with their CPA on a multi-year strategy to convert some of their IRA assets to a Roth IRA, and the amount of tax to be paid will be offset by losses from their business operations. The clients have over $1,000,000 in IRA assets; in 2009 we were able to convert $170,000 at a very low tax rate.   In 2010 and 2011 we should be able to convert most of the remaining assets with a minimal tax hit because they will have one more year of business losses. Ultimately, the clients will have less hassle from running a business in retirement and enjoy tax free income when needed.

“This is a once-in-a-generation opportunity to transfer wealth to your heirs and minimize millions of dollars in wealth transfer taxes.”

There are a significant number of tax and financial considerations that come into play when determining whether to convert your traditional IRA to a Roth IRA. For example, you might want to convert some, but not all, of your IRA assets to a Roth IRA. Also, the decision to convert will likely be based on assumptions about future income tax rates and rates of return from the investments, that may not turn out as expected. If you have any questions about traditional IRA to Roth IRA conversions and the new 2010 planning opportunity, please contact our office to set up a planning phone call or meeting.