Opportunity Knocks

The Roth IRA was introduced in 1998. While it has proven to be a very popular alternative to traditional IRAs, IRS income limits have prevented many from taking advantage of its unique features. This is all about to change.

Beginning in 2010, anyone with a traditional IRA will be eligible to convert to a Roth IRA, regardless of income. While the restrictions on direct Roth contributions will remain, the Roth structure will effectively be opened to all. Nondeductible contributions made to traditional IRAs, and qualified distributions from retirement accounts will also be eligible for conversion.

With 2010 right around the corner, now may be a good time to survey the coming changes.

A Little Background

Contributions to traditional IRAs are made on a pretax basis. Investors receive a tax deduction for the amount contributed, but must pay taxes on all withdrawals. Roth IRAs work in reverse. Contributions are funded with after-tax dollars, meaning no upfront tax deduction. In return, however, all future withdrawals from the Roth IRA are received tax-free.

When converting from a traditional to a Roth IRA, tax must be paid on the converted amount. This is simply an unwinding of the deduction originally received for contributing to the traditional IRA, in exchange for the future tax-free benefits of the Roth.

The Cost of Admission

Many are sure to find the advantages of a Roth conversion compelling. However, coming up with the money needed to pay the tax bill may be a challenge. While funds from the original IRA can be used to pay the taxes, doing so reduces the benefit of converting, as it decreases the amount of tax-advantaged funding.

To help those who would like to convert but find themselves a little short on cash, current regulations will allow taxpayers who convert in 2010 to claim the resulting income, equally divided, in 2011 and 2012. Therefore, the tax liability resulting from those choosing to convert in 2010 can essentially be deferred until taxes are filed in 2012 and 2013.

This deferral option applies only to conversions made in 2010.

Who Should Convert?

The future course of tax rates will go a long way in determining whether converting ultimately proves beneficial. If future tax rates and income combine to place you in a higher marginal tax rate in the future, the taxes saved on future distributions will more than offset the tax paid to convert. On the other hand, lower future marginal rates would favor staying with a traditional IRA.

So how can we decide whether to convert when the ultimate benefits depend on an unknowable future? There are reasons to consider converting at least a portion of your retirement assets that do not rely solely on the future direction of marginal tax rates. In fact, one reason for converting some portion of retirement assets to a Roth IRA is precisely because we cannot know what the future will bring.

Tax diversification is a term used to describe the spreading of assets across investments and investment vehicles with differing tax characteristics. In addition to the uncertainty of future rates, new and changing legislation can alter the landscape at any time, and may have a disproportionate effect on one or more forms of retirement savings. Most individuals have the bulk if not all of their retirement assets in traditional tax-deferred accounts (traditional IRAs, 401(k)s, pension plans). If you are in this camp, diversifying your tax exposure by converting at least a portion of these assets to a Roth IRA is something to consider.

Some taxpayers, unable to deduct past IRA contributions because of employer coverage and related income limits, have instead made nondeductible contributions. Since taxes have already been paid on these contributions, they can be converted tax-free. You will be subject to tax on any accumulated earnings, but the prospect of turning taxable into tax-free funds at no charge is a rare opportunity indeed. Of course, there is a catch.

If you have also made deductible contributions and wish only to convert a portion of your IRA assets, special rules apply. In this case, the amount of the conversion considered nondeductible is determined by the overall portion of nondeductible contributions relative to the total combined IRA assets. For example, if you have made a total of $50,000 in nondeductible contributions, and your combined non-Roth IRA assets across all accounts is $250,000, then 20% ($50,000/$250,000) of any conversion will be deemed a conversion of nondeductible contributions, and thus tax-free.

Individuals with other sources of retirement income, who would like to leave their IRA to children or grandchildren, can also benefit from converting. Unlike traditional IRAs, Roth IRAs do not have any minimum distribution requirements. Thus, assets can grow, untouched and tax-free, throughout your lifetime. Distributions taken by your heirs after inheritance will remain tax free, making this arrangement akin to life insurance that pays out over the lives of your beneficiaries.

The “Recharacterization” Option

An interesting feature of the Roth conversion rules is the option to “recharacterize” a converted Roth IRA back to its original IRA status. Recharacterization restores the original account status to that existing prior to the conversion. Taxpayers have until October 15 (with a tax filing extension) of the year following conversion to recharacterize. Taxpayers may wish to choose this option if the value of the converted IRA declines significantly, pushing the value below the taxable amount that resulted from the conversion. Recharacterized accounts can be converted again after 30 days, with the provision that an account cannot be converted more than once in a given tax year.

Since there is no limit to the number of separate Roth accounts an individual can set up, this recharacterization option also provides the potential for more finely-tuned tax optimization. For example, a taxpayer could convert a traditional IRA into two separate Roth IRAs, transferring all the stock holdings into one account, and all the bonds into the other. If the stock account were to subsequently decline in value while the bond account rose, the taxpayer could recharacterize the Roth IRA containing the stocks, while maintaining the account holding the bonds. The account holding the stocks could then be converted again at the lowered value, thus reducing the taxable income reported on the conversion.

This strategy can be extended to multiple asset classes or even individual investments, setting up separate accounts for each, and later cherry-picking the winners while recharacterizing the losers. The procedure can then be repeated the following and subsequent years if need be.

This option can also be used as a safety valve for those who want to convert, but are wary of committing to a large tax outlay in these economically uncertain times. A taxpayer converting on January 1 of 2010 or any year thereafter, has a minimum of 15 ½ months (until April 15 of the following year, longer with a filing extension) to see what unfolds, and reverse course if necessary.

Additional Considerations

Other factors to consider include the added flexibility of the Roth distribution rules as compared to those of the traditional IRA. For example, while there is a five-year holding period and age 59 ½ requirement for qualified distributions from a Roth IRA, the ordering rules effectively allow distributions of the converted basis after the five-year period, regardless of age. Of course every effort should be made to avoid dipping into retirement assets early, but many may nonetheless take comfort in this added flexibility.

More importantly, as mentioned earlier there are no required minimum distributions with a Roth IRA. Owners are free to take distributions as needed in retirement, or let the assets grow.

Finally, for Roth IRA owners who take distributions in retirement, an added benefit is that these distributions are not counted as income when determining the taxability of social security benefits.
When looking at the upfront tax cost of converting, taxpayers should consider the effect of the conversion income on their marginal tax rate, as well as on any other deductions or credits. Also, tax rates are scheduled to increase beginning in 2011, so include this in the analysis if considering the 2011-2012 deferral option.

There are many factors to consider when deciding whether to convert to a Roth IRA, and the IRA rules can be very complex. If you believe a Roth conversion may be right for your circumstances, now might be a good time to start planning.
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