***UPDATE 04/07/2013**** As I was working on a return today for a new client with Roth conversions that include both traditional and non-deductible IRAs, I remembered THIS blog entry and thought — clarification is needed. So here I am, back to clarify. Please note that I say right off the bat in this blog that when you have “nondeductible IRAs in the mix,” a conversion to a Roth is complicated with allocations — no pick and choose methodology allowed. Then right below that I say, wow, a loophole! And I suggest doing just that: contribute to a nondeductible IRA and convert it to a Roth. Well…here is the clarification — IF you already HAVE IRAs, doing this flip is NOT easy and NOT without taxation. Because I am busy beyond comprehension today, I cannot go into a big explanation, so I found this article quickly from Forbes and it is pretty good: http://www.forbes.com/sites/josephsteinberg/2012/12/12/warning-about-roth-ira-conversions-often-misunderstood-irs-rule-can-cost-you-money-and-aggravation/. Suffice to say that my new client is not going to like what I have to tell him today — that what he thought would be nontaxable is indeed quite taxable because he cannot simply flip his new nondeductible IRA — he has to take into consideration the other $150,000 in IRA investments–which means that the flip is mostly taxable. He got bad advice. And his predecessor tax preparer did not know any better either.
01/04/2010
2010 sees the fruition of The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) signed into law by the Bush Administration. Three important features:
1. There are now no income limitations for Roth conversions (although there are still income limitations for directly funding a Roth—see below). All taxpayers are eligible to convert;
2. Taxpayers who file “married filing separately” may now convert IRAs to Roth IRAs;
3. ONE TIME OFFER: you can report income from a Roth IRA conversion completed in 2010 in two equal installments on your 2011 and 2012 tax returns (that means you can choose NOT to declare the income on your 2010 return and defer equally to 2011 and 2012).
First, my editorial comment: the government loves this deal because it accelerates tax collection. When you convert your Traditional IRAs to Roths, you will recognize income NOW and pay tax NOW on money that you might not have recognized as income for many many years.
That said, the ability for all taxpayers to convert Traditional IRAs to Roths may prove to be a good thing for you – but you need to analyze it for your individual situation. One size does not fit all. Here are a few thoughts:
• MARGINAL TAX RATE (ie your “tax bracket”): When you convert previously tax deferred funds from a Traditional IRA or a Rollover IRA, you will be taxed NOW at your current tax rate. If you think your tax rate will be lower when you retire, then you might consider leaving your Traditional/Rollover IRA in place. Of course…almost everyone believes tax rates will go up, which would make conversion today more attractive. And then there is the specter of inflation that could detract – why pay dear dollars today for cheaper money in the future? No one has a crystal ball.
• TIME TO ACCUMULATE: To avoid taxation on a Roth IRA’s growth, the funds must be in place for a minimum of 5 years. So, if you will need to tap into the funds in less than 5 years, a conversion might be inadvisable. If you have previously funded a Roth that has been in place for 5 years, you are probably “good to go.” From an investment perspective, the longer your Roth is in place, the more advantageous it could be. But we are all a tad “sadder and wiser” these days and know that length of time invested does not always mean more money in the end.
• CAN YOU PAY THE TAX NOW?: If you have to use money from the IRA itself to pay the tax on the conversion, you will have taken an actual distribution that will reduce the funds available to be invested. It will take you a long time to make up for the reduction of the asset base. And if you are under age 59.5 you will be faced with 10% penalties as well as income tax (because you are deemed to have taken a distribution from the IRA prior to “retirement age”).
• NON-DEDUCTIBLE IRAs IN THE MIX: If you have funded Nondeductible IRAs in the past, the Roth conversion gets tricky because you are not allowed to pick and choose between the Nondeductible and Traditional/Rollover IRAs you convert. You must include an allocation of both deductible and non-deductible IRAs. Get help.
On the upside:
• MARKET HITS: If the value of your Traditional IRAs remains depressed after the 2008 debacle, this would be a great time to move them to a Roth. Low values = less taxable income.
• NO MINIMUM DISTRIBUTIONS REQUIRED (THIS IS THE BIGGIE, IN MY OPINION): Every year after you have reached age 70.5, you MUST withdraw a certain minimum amount from your Traditional/Rollover IRAs and recognize the income on your tax return for that year. Roths, because the distributions are tax exempt, have no minimum distribution required. That means, you can take money out and not increase your adjusted gross income – thus making some deductions more deductible and some income less taxing (ie Social Security inclusion income). I think that this item in and of itself is a very compelling reason to convert to Roths.
• FOR YOUR HEIRS: Because the taxes have already been paid, Roths can reduce the size of your taxable estate and are passed to the beneficiaries without further taxation.
• TAX DECISION: On the conversion, you can pay the tax in 2010 or split it between 2011 and 2012. That seems like a no-brainer, but consider your marginal tax rate. If you are unemployed currently, for example, your tax rate may be very low in 2010 but could be much higher in 2011 and 2012. Therefore, it might be wise to pay the tax now at an overall lower rate.
• OVERCOME INCOME LIMITATIONS – OH MY GOSH, A LOOPHOLE?? There are still income limitations to funding a Roth IRA in 2010 – adjusted gross income for singles = $105,000 and for marrieds filing jointly $167,000. If your income exceeds those limits, you may not fund a Roth. Here is the APPARENT LOOPHOLE. It appears that you could fund either a Traditional or Nondeductible IRA during 2010 and then convert to a Roth before the end of the year. That seems like a lot of paperwork but could be worth it. What was Congress thinking about back in 2005? Why not just take the cap off altogether? Incidentally, the income limitations for funding Roths for 2009 (ie due by April 15, 2010) are $105,000 singles and $166,000 marrieds filing jointly. [update – SEE CLARIFICATION ABOVE!!! THIS IS TRICKY — NO PICK AND CHOOSE — CAN BE QUITE TAXABLE]
Bottom line on a Roth Conversion – unless your situation is pretty straight forward, get help from your financial advisers. You might also take a look at one of the many IRA to Roth conversion calculators on the internet. There is one on Schwab that is easy to use (but I cannot guarantee its accuracy). Just search on your browser for Roth Conversion Calculator and try a few of them.
And for all of you who were burned in the recent past trying to convert IRAs to Roths – tax law is not fair and if you wait a few minutes, it will change. Sort of like the weather.