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There has been a large amount of media and
investment advisor attention to the “Roth Conversion” options in
2010. I wanted to give you my two cents on the good, the bad and the
ugly of Roth Conversions.
Prior to 2010, the income limits on both kinds of
IRAs have prevented higher income taxpayers like many of my clients
from making deductible contributions to traditional IRAs, or a
contribution to a Roth IRA. Although you could make nondeductible
contributions to a traditional IRA, the tax benefits were limited
(i.e., no current deduction, the tax on the IRA income is deferred
rather than eliminated, and minimum distributions are required).
However, for tax years beginning after December 31,
2009, a conversion from a traditional to a Roth IRA can be made
without regard to your income or filing status. Therefore, if you
are a married individual filing separately, or have adjusted gross
income greater than $100,000, you are no longer precluded from
making a Roth IRA conversion. The elimination of the rules related
to IRA conversions may provide you with a unique tax planning
opportunity.
Although the income limitation on Roth IRA
conversions is permanently repealed, there is a special tax
treatment available for 2010 conversions only. Conversion income in
2010 is recognized ratably in 2011 and 2012, unless you make an
election to recognize all of the income in 2010.
There are several valid reasons why you may want to
take advantage of the opportunity to convert to a Roth IRA, other
than the obvious tax-free withdrawals and not being subject to
required minimum distributions during your lifetime. These include
the recent devaluation of your IRA investments, hedging against
future tax rate increases, offsetting any current year net operating
losses, or estate planning.
The following key factors generally need to be
identified and addressed in order to best analyze a Roth IRA
conversion:
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Asset mix (i.e., qualified versus nonqualified,
liquid versus illiquid)
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Traditional IRA fair market value
-
Time horizon
-
Current and future cash flow needs
-
Current marginal tax rate versus projected
future marginal tax rate
-
The ability to pay the income tax on a
conversion with nonqualified funds
-
Estate planning objectives
In addition to the above one must analyze the tax
bracket that they will be in the next few years to determine if
conversion is even a good idea. If a client is at the top of their
income producing years a conversion would not be a very good idea as
you would be taxed on those dollars at your highest rate. It is also
important to discuss how to pay the taxes. I am advising that
clients use non qualified assets to pay the tax rather than reducing
the amount of the conversion to pay the tax. The amount withheld to
pay taxes is subject to the 10% penalty on early withdrawals so the
effective tax rate on those dollars could be as high as 45%. Painful
to say in the least.
As you can see, whether a traditional IRA should be
converted to a Roth IRA is a complex issue. Please call our office
if you have questions or want to schedule a review of your
retirement scenario and to discuss the conversion strategies
available to maximize your tax benefits.
Michael T. McCormick, JD, LL.M.
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