07/10/09 - 2010: The Year of the Roth Conversion

By: Richard Feldman, CFP®, MBA, AIF®

Right now investors have the unique opportunity to keep more of their assets on a long term basis and shelter their retirement funds from increasing federal and state taxes by moving these funds to Roth IRAs while taxes are at historically lower levels.  Given the economic downturn that we have experienced over the last year and a half, it is now more important than ever to make sound long term financial planning decisions regarding your assets. The increasing federal and state budget deficits along with Social Security and Medicare shortfalls practically guarantees higher taxes both at the Federal and State levels.

Roth IRA Basics

Roth IRA distributions are tax-free if distributed after age 59 ½ and after the account has been open for five years.  In addition, Roth IRAs do not have any mandatory required minimum distributions for owners 70 ½ years old or older.

Typically, you have access to a Roth through three vehicles: a Roth IRA, Roth Conversion, and Roth 401k.  The Roth IRA currently allows contributions in the amount of $5,000 and if you are over the age of 50, you are eligible for a catch up contribution of $1,000 as well.  The maximum annual Roth IRA contribution limit is phased out if your modified adjusted gross income is between:

• $166,000 and 176,000, if you are married filing jointly, or a qualifying widow/widower
• $105,00 and $120,000, if you are single, head of household, or married filing separately and you lived apart for the entire year
• $0 and $10,000, if you are married filing separately and you lived with your spouse at any time during the year

Another vehicle that you may use to access a Roth IRA is a Roth Conversion.  If your Modified Adjusted Gross Income (MAGI) is $100,000 or less, and you are not married filing separately, you may make a taxable conversion of a traditional IRA or IRA rollover to a Roth IRA.  This limit is for individuals who are single or married.  The Tax Increase Prevention and Reconciliation Act enacted in 2006 has alleviated the $100,000 MAGI limit for Roth Conversions starting in 2010 opening up a major financial planning opportunity for individuals and families that have been phased out of eligibility for a Roth IRA in the past or who have large IRAs and would like to convert a portion of their IRA accounts for tax and estate planning purposes.

In addition, the market sell off that has decimated retirement accounts in 2008 means individuals can convert their before tax retirement accounts to Roth IRAs and pay less taxes now and any future growth obtained in those accounts would be tax free as long as you meet the age and five year holding period requirement.

Roth Conversions 2010

Roth conversions are available to individuals who have traditional IRAs, rollover IRAs, Simple IRAs, and SEP IRAs. With a Roth conversion you have the ability to spread the taxability of the income ratably over the 2011 and 2012 tax years.  Typically, a conversion is taxable in the year of conversion but the TIPRA act of 2006 lets you choose between including the conversion in your taxable income in 2010 or spreading it ratably over the 2011 and 2012 tax years.  The government would essentially be providing you an interest free loan for two years to pay the conversion tax. 

Roth conversions for younger individuals in lower tax brackets are a must.  Younger individuals who have small retirement accounts or 401K accounts from previous employers are apt to benefit the most from a Roth Conversion due to their long investment time horizon and the ability to grow their funds for a longer period of time on a tax deferred basis.

Required Minimum Distributions

A major benefit of Roth IRAs is that they do not have any requirement to distribute money from the accounts due to Required Minimum Distributions rules that kick in for traditional pre-tax retirement vehicles at age 70 ½.  This allows the funds to compound for an extra twenty to thirty years in some cases and is ideal to leave to your spouse, children, or grandchildren due to the fact that all sources of distributions are tax free to recipients.

Due to the suspension of Required Minimum Distributions in 2009 by Congress, it might not make sense to wait until 2010 to do a Roth Conversion since you might be in a lower tax bracket in 2009 than in 2010, 2011 or 2012 (assuming you meet the $100,000 MAGI limit in 2009).  Another strategy might be to take the amount that you were going to be required to take out of your retirement account under the required minimum distribution schedule and roll that over to a Roth IRA thus maintaining your same income tax bracket from the previous year and getting your Roth IRA started as well.

Summary

The relaxation of income limits on Roth IRA conversions in 2010 has created a major planning opportunity for families that will be subject to the estate tax and high income individuals that do not currently have access to a Roth IRA.  Since individual circumstances, estate taxes, and future tax rates will determine if a Roth Conversion would be beneficial, please consult your tax or legal professional for a detailed analysis.

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