In planning for retirement, choosing appropriate investments is an important consideration. But equally significant is choosing the most appropriate retirement vehicle.
As a result of a tax law change that took effect this year, there are no longer income limitations for a conversion to a Roth IRA. Thus, wealthy taxpayers who may have been shut out of Roth IRAs in the past have new opportunities to convert some or all of their traditional retirement accounts into Roth IRAs, says Steven Y. Patler, JD, CPA, a senior manager at Cendrowski Selecky PC.
“One thing is certain about Roth IRAs: the conversion decision is complex and very taxpayer specific,” says Patler.
Smart Business spoke with Patler about what to consider when deciding whether a Roth IRA conversion makes economic sense for your situation.
How is a Roth IRA different from a traditional IRA?
The most significant difference is that all distributions from a Roth IRA can be income tax free if certain requirements are met, such as age and holding period. On the other hand, there is no tax deduction for contributing to a Roth IRA.
Also, unlike traditional IRAs, there are no minimum required distributions during one’s lifetime. Eligibility for making contributions to a Roth IRA also differs.
How is a Roth IRA funded?
Basically there are two methods to fund a Roth IRA, annual nondeductible contributions and qualified rollover contributions, also known as conversion. Currently, annual contributions are limited to a maximum of $5,000 $6,000 for those ages 50 and older per year, and contributions made during the year to other IRAs may reduce this amount.
There are also income limitations for annual contributions, and no annual contributions can be made if a married couple’s modified adjusted gross income exceeds $177,000 ($120,000 for single) in 2010.
By far the biggest opportunity to fund a Roth IRA is through conversion. Unlike annual contributions, there are no income limitations for Roth IRA conversions starting in 2010, and any individual can convert a traditional IRA, SEP IRA, Simple IRA and eligible qualified retirement plan rollovers (including 401(k), etc.) to a Roth IRA.
Is there a cost to convert to a Roth IRA?
Yes. All amounts converted to a Roth IRA, except for after-tax contributions, are treated as taxable income and subject to tax on the individual’s tax return. After-tax contributions are those contributions made to an IRA or retirement plan in which the taxpayer did not obtain a deduction.
Paying tax on a Roth conversion is inherently contrary to most people’s thought process of paying less tax now. Although this is by far the biggest obstacle, the effects may be mitigated with proper planning.
Why would someone consider a conversion to a Roth IRA if there are tax consequences?
Because for many taxpayers, the current tax cost on a conversion will be overshadowed by potentially substantial tax savings in the future. The determination of whether a conversion should be made is quite involved, and because it involves projecting the future, it will be partially assumption based.
Only a person who is very knowledgeable about the tax law and about an individual’s particular family and tax situation should perform this analysis.
One factor to evaluate in determining whether a Roth conversion makes sense is the taxpayer’s current marginal tax rate and his or her expected marginal tax rates in the future. Obviously, predicting future tax rates is not something that can be done with precision; however, one can model various scenarios to determine the impact at varying tax rates. In general, if one predicts the taxpayer and/or his or her heirs will be in higher tax brackets in the future, it is more likely that conversion will be beneficial.
Another factor to consider is whether the taxpayer will be able to pay the taxes due on conversion with funds that are not in a retirement plan. The benefits of converting to a Roth IRA will be lessened if outside funds aren’t available to pay taxes due on conversion.
When does a taxpayer have to pay tax on the conversion?
For this year only, there is a special rule that takes the Roth conversion income and removes it from a taxpayer’s 2010 tax return and places half of the income in 2011 and the other half in 2012. Although this may sound like a great deal, it may not be because a taxpayer’s marginal tax rate may be higher in 2011 and 2012 than it is now.
Fortunately, taxpayers can opt out of this special rule if they wish and instead include all of their income in their 2010 tax return.
What if a taxpayer converts funds to a Roth IRA now and then his or her portfolio declines in value?
If the decline occurs prior to the extended due date of the tax return for the year of the conversion, the taxpayer can undo the conversion. For conversions in 2010, that would mean a taxpayer may have until Oct. 17, 2011, to decide what to do.
But the trustee must be alerted of the taxpayer’s desire to recharacterize the conversion. <<
Steven Y. Patler, JD, CPA, is a senior manager at Cendrowski Selecky PC. Reach him at (248) 540-5760 or firstname.lastname@example.org.