Effective January 1, 2010, individual taxpayers are allowed to convert their traditional IRAs into “Roth” IRAs. Before 2010, only individuals with modified adjusted gross incomes under $100,000 were eligible to make this conversion.
For certain taxpayers, strong consideration should be given to converting their traditional IRAs into Roth IRAs. However, this opportunity is clearly not for everyone and does have certain drawbacks, including the requirement to pay income tax on the amount converted.
For individuals who opt to make the conversion now, an escape mechanism, called a re-characterization (effectively eliminating the conversion), may be made through the extended due date of the 2010 tax return. This allows taxpayers to change their minds regarding Roth conversions through October 17, 2011, which provides significant planning opportunities.
Traditional IRAs vs. Roth IRAs
Traditional IRAs allow for tax-deferred investing. Contributions to a traditional IRA may or may not be deductible, depending generally on the taxpayer’s adjusted gross income (AGI) and eligibility by the taxpayer, or his or her spouse, to participate in an employer’s retirement plan. Earnings on IRA contributions are tax-deferred. When distributions are taken from traditional IRAs, the portion representing deductible contributions and earnings is subject to federal, and possibly state, income tax. Distributions must begin once an individual reaches age 70½ under the required minimum distribution rules. Beneficiaries who inherit IRA accounts are also subject to required minimum distribution rules (generally requiring distributions to be taken out over their life expectancy) and are subject to similar income tax burdens.
The value of the traditional IRA is included in the taxable estate of an account owner for estate tax purposes, and as noted above, beneficiaries are subject to income tax on distributions. When beneficiaries report these distributions on their income tax returns, they may be allowed a pro-rata deduction for the estate tax paid on the value of the IRA accounts they inherited, thus avoiding double taxation. Therefore, combined estate tax and income tax on a traditional IRA account bequeathed to a non-spouse beneficiary may exceed 70%.
A Roth IRA does not allow for deductible contributions. In other words, contributions to a Roth IRA never give rise to income tax deductions regardless of the taxpayer’s AGI. However, as long as certain requirements are met (including a five-year holding period and attainment of age 59½), a distribution of contributions or earnings will be income tax free. Moreover, the required minimum distribution rules do not apply to the owner of a Roth IRA, thus allowing for additional tax-free deferral for the owner’s lifetime. However, the required minimum distribution rules do apply to a beneficiary who inherits a Roth IRA account, although such distributions are income tax-free.
The value of a Roth IRA is included in the owner’s taxable estate. However, because distributions are generally tax-free to an account beneficiary, Roth IRAs are more tax efficient than a traditional IRA. Moreover, paying the associated income tax on conversion before death and before computation of the estate tax is much more tax efficient than the deduction allowed traditional IRA beneficiaries for estate tax paid on the value of the IRA account.
The Roth IRA is clearly a superior savings vehicle when compared to a traditional IRA for most people. However, AGI limitations generally prevent higher income individuals from contributing to Roth IRAs. Hence, higher income individuals should consider taking advantage of the opportunity to convert a traditional IRA into a Roth IRA.
Implications of a Roth Conversion
Converting a traditional IRA into a Roth IRA is a taxable event in the year of conversion. Income tax is due on the amount of deductible contributions and cumulative net earnings. By paying the income tax on conversion, however, future distributions to the owner and/or his or her beneficiaries become tax-free.
A special rule applies to conversions in 2010. The IRA owner is allowed to report the conversion income in 2010, or may instead report the income in two installments - 50% of conversion income in 2011 and the remaining 50% of conversion income in 2012.
Generally, deferring a tax liability makes good sense. However, with the anticipated increase in income tax rates scheduled to begin in 2011, it may make sense to forego utilizing the deferral opportunity.
Notwithstanding the timing decision as to when to report the conversion income, it is clear that the funds used to pay the tax liability should not come from the IRA account. Instead, in order to optimize this opportunity, the IRA owner should use other existing funds to pay the conversion tax.
Re-characterization - A Chance to Un-ring the Bell
The rules allow a taxpayer to re-characterize a Roth IRA conversion until the due date of the 2010 tax return. By utilizing the automatic tax return extension provisions, the taxpayer will have until October 17, 2011, to determine whether the Roth IRA conversion makes economic sense. If it does not, the taxpayer could reverse the earlier decision, thus changing the Roth IRA account back into a traditional IRA.
For example, if a taxpayer converts a traditional IRA worth $250,000 on December 1, 2010, and by October 17, 2011, the account grows to $300,000, an increase of $50,000, the taxpayer will likely opt to stay the course and leave the account in a Roth IRA wrapper. As of that date, the taxpayer would have sheltered $50,000 of income, as well as any future income and growth for his or her lifetime, at a cost of paying the tax associated with the initial $250,000 conversion.
On the other hand, if the taxpayer’s account falls to $200,000, a reduction in value of $50,000, the taxpayer will likely opt to re-characterize the initial conversion back into a traditional IRA, thus avoiding the need to pay the tax on the initial $250,000 conversion.
Assuming for a moment that the taxpayer is in the highest federal tax rate (35% for 2010), and again assuming that 100% of the account value is subject to taxation, the taxpayer would have paid $87,500 (35% x $250,000) for the opportunity. In the instance where the account grows to $300,000 as of the extended due date (the end of the opportunity to re-characterize), the taxpayer’s effective federal tax rate falls to 29.2% ($87,500/$300,000), justifying the original election.
The re-characterization decision becomes much less clear when the account does not grow at such a robust rate. If the account grew only slightly or was flat, then a more sophisticated quantitative analysis must be performed in order to justify the initial election. Consideration must be given to the taxpayer’s need to access the account, future income tax rates applicable to the owner and the owner’s beneficiaries, the life expectancy of the account owner, the ages of the likely beneficiaries, and future return rates on investment.
However, because of the re-characterization opportunity, there is little downside in making the initial election in 2010.
Asset Allocation Considerations
Clearly, an investment decision should be made in the context of one’s risk tolerance, goals and objectives, and asset allocation model. However, one may wish to consider establishing multiple Roth IRA accounts (by asset class) as part of the conversion strategy. For example, if multiple Roth IRA accounts are set up to separately hold one’s large-cap value, large-cap growth, small-cap value, small-cap growth, international developed markets, international emerging markets, commodities, domestic bond and international bond holdings, etc., rather than setting up just one Roth IRA account to hold all asset classes, then the decision next October 17th might be easier. At that time, the winning asset classes could continue in their Roth IRA package, while the losers could be re-characterized back into traditional IRAs.
Who Might Benefit?
The IRA owner’s specific situation should be analyzed before making a conversion decision, but the following rules of thumb might provide some context before running the numbers. As with any generalization, exceptions apply, and a final decision should be based on the owner's specific situation.
For taxpayers who will not need their traditional IRA assets to live on during their retirement years, have the necessary funds outside the IRA accounts to pay the conversion tax, and will likely bequeath the IRAs to non-spouse family members, conversion should be strongly considered. This also holds true for individuals who plan to use some or all of their IRA accounts to fund credit shelter trusts pursuant to their estate plans.
Taxpayers who will be in a low tax bracket for 2010, due to job losses or net operating loss carry forwards, or other attributes that could shelter some of the conversion income, are also viable candidates for the conversion.
On the other hand, taxpayers who will need to use their IRA accounts for retirement living expenses sooner rather than later, and will likely be in lower tax brackets in their retirement years, would not be viable candidates for the conversion.
Moreover, a taxpayer who is charitably inclined, and is expected to utilize his or her IRA for charitable purposes during lifetime or at death, would also not be a candidate for the conversion.
In any event, non-spouse IRA beneficiaries may not convert an inherited IRA account.
Another consideration is whether a taxpayer is expected to have a taxable estate at death. At present, with the estate tax regime still up to Congress, some taxpayers may not know whether they will have a taxable estate, since the amount of the estate tax exclusion is under debate. However, if a taxpayer is not expected to have a taxable estate, a Roth conversion may not be appropriate.
The length of time the account balance will stay an IRA is also a consideration. Everything else being equal, the longer the account balance remains in the IRA, due to the age of the owner and/or the ages of the beneficiaries, the stronger the case for a Roth conversion.
It is likely that most situations will require a taxpayer to “run the numbers” before ultimately deciding on whether to convert. However, with the re-characterization opportunity which effectively gives taxpayers the ability of 20/20 hindsight, there is little downside to making a Roth conversion in 2010. Optimization, which would take into account both current and future marginal tax rates, future estate tax liabilities and rates, and investment performance projections, are clearly appropriate but are not back of the envelope exercises. It very well may be that partial conversions may be the optimal strategy.