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Tuesday, February 2, 2010

Heads up: Roth IRA conversions take 2010 by storm

By Kevin Reardon
By now, most people are aware that 2010 is a special year for Roth IRA conversions. Previously, only those with Modified Adjusted Gross Income (MAGI) below $100,000 were allowed to convert IRA assets to Roth IRAs. In 2010, the income ceiling for Roth conversions is permanently repealed. High income earners have a new planning opportunity available to them.

A Roth conversion is a complex financial planning issue that requires a detailed look at each individual's situation, along with making judgments regarding future taxable income, and future tax rates when distributions might occur. Before examining the pros and cons of a conversion, let's step back and examine the characteristics that go with Roth IRAs and conversions.

Roth IRAs have been around for 12 years, allowing individuals to contribute after-tax money into these accounts. Once in the accounts, assets grow tax deferred like traditional retirement accounts. The difference, however, is that qualified Roth IRA distributions are tax-free, whereas distributions from other tax deferred accounts (401ks, IRAs, Annuities) are taxable.

Individuals in higher income brackets are prohibited from contributing to Roth IRAs, forcing them to direct savings into tax deferred accounts. As tax deferred account balances grow, the challenge for individuals without Roth IRAs is revealed as they near retirement. Not only are distributions from traditional IRA and 401k plans taxable, but the distributions frequently push individuals into higher tax brackets, increase the taxability of Social Security benefits, and reduce available deductions or exemptions. Lastly, at age 70 1/2, traditional IRA account owners are forced to take Required Minimum Distributions (RMDs), increasing their tax liability.

Wisconsin residents should know that the state has not adopted P.L.109 222 to recognize Roth conversions. Unless Wisconsin adopts this law, taxpayers under age 59 1/2 with income over $100,000 will be faced with an early withdrawal penalty of 3.33% and an excess contribution penalty of 2% annually. Fear not, as a technique known as a "Roth Re-characterization" allows us to reverse a Roth conversion as if it never happened. Therefore, this current rule should not prohibit us from leveraging this technique.

The tax resulting from Roth conversions can be deferred, and split between your 2011 and 2012 tax returns. Pushing the tax into these years can be a smart decision if you are confident you will be in a similar or lower tax bracket than you are in 2010. With tax rates slated to rise in 2011 for those in the 25% income tax bracket and above, paying the tax in 2010 may be the right option.

The following are several reasons why someone might convert to a Roth IRA. This list is a starting point as you discuss your overall financial plan and goals. Please consult with your financial advisor or CPA before proceeding with a conversion.

Reasons to Convert to a Roth IRA

1. Liquidity: A Roth conversion will generate income taxes. To maximize the benefit of the conversion, you should have liquid assets available outside of the IRAs to pay the conversion tax.

2. No Need for your IRA Money: If you have sufficient assets outside of your retirement accounts and won't need your IRA assets, converting to a Roth IRA is a strong consideration. Roth IRAs do not have Required Minimum Distributions (RMDs) like traditional IRA accounts. This gives more tax control to individuals who may not need to access IRA assets until after age 70 1/2.

3. Tax Control: Income stacking occurs when you begin adding up all of your income sources in retirement. It is not uncommon for individuals to have earned income, social security income, pension income, interest income, dividend income, passive income from real estate investments, and short term and long term capital gains. If you need to take a distribution from an IRA, or are forced to take an RMD, this income is added to your other income sources and could push you into a higher tax bracket or simply increase your tax liability. You have less control of your income tax liability when you have assets in an IRA relative to a Roth IRA.

4. Inheritance: In relation to #2 and #3 above, if your children are likely to inherit your IRA, Roth IRAs are a fantastic asset to pass to the next generation as distributions are tax-free. Forecasting the tax-free growth of this asset over two generations will demonstrate a huge advantage of Roth IRAs over traditional retirement accounts. If your children are likely to be in a similar to higher tax bracket than you, consider a conversion.

5. Future Tax Rates: By converting your IRA to a Roth IRA in 2010, you can pay tax at a known rate (2010 tax rates if you choose), and a rate that is low relative to historical tax rates. In addition to potentially rising tax rates, keep in mind that certain deductions, exemptions, and credits may be reduced moving forward, further increasing your tax liability. If you think you will be in a similar or higher tax bracket in retirement, a conversion today can make sense.

6. Tax Diversification: Most individuals have after-tax accounts (savings accounts, investment accounts, etc.) and tax deferred accounts (IRAs, 401ks, Annuities) but don't have a tax-free Roth IRA account. By converting some or all of your IRA assets into a Roth IRA, you can choose which accounts to draw from in retirement to best maximize your situation and to diversify some of your assets against future tax changes.

7. Reduced Market Values: Given the low returns of the last decade, many retirement accounts are at low levels. Converting accounts now, while values are low, moves an asset to a tax preferred account with minimum tax liability. Conversions early in 2010 are recommended.

8. Favorable Tax Attributes: Charitable deduction carryovers, investment tax credits, or low current income in 2010 are all incentives to do Roth conversions in 2010.

9. Income Tax Bracket Filling: If you have room within your current income tax bracket to incur more income, than a partial Roth conversion is a great way to maximize your current bracket.

10. Estate Planning: Although Roth IRAs are included in your taxable estate, a Roth conversion helps to reduce the value of your estate (via the income tax -- which is lower than estate tax). In addition, Roth IRAs are not subject to estate and income taxes when withdrawn by your beneficiaries.

-- Reardon is owner & president of Brookfield-based Shakespeare Wealth Management Inc.


Comments: 8

At February 2, 2010 at 2:43 PM, Blogger Sarah said...

Hi Kevin,
Thanks for the interesting article. I hope my question is not too complicated.
If for example I convert a $50,000 IRA to a Roth IRA in 2010, and my income for the year 2010 is only $25,000, will my taxes owed be based on both my Roth IRA amount and 2010 income, or will they be calculated separately irrespective of my income for the year 2010? How much will my taxes be in this example?

At February 3, 2010 at 9:35 AM, Blogger Kevin said...


Great question. Assuming your IRA has all tax deferred assets inside of it (no non-deductible contributions), then the $50,000 conversion will be added to your earned income. Not only will you pay tax on $75,000 of income, but it is possible the conversion amount will push you into a higher tax bracket.

The law does allow you to options: 1. With a full conversion, you can defer paying this tax over two years, 2011 and 2012. If you think you'll be in the same income bracket for the next few years, then spreading the tax over two years may make sense. 2. You could do a series of partial conversions: convert some of your IRA in 2010, some in 2011, and so on.

This is a tricky area, with lots of variables to consider. Be sure to consult with your tax advsisor.

Kevin M. Reardon, CFP

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