A traditional Individual Retirement Account (IRA) allows a taxpayer to place pre-tax dollars into the IRA, defer tax on the growth of the account, and pay regular income tax on the money when it is withdrawn.
With a Roth IRA, after-tax dollars are deposited but all subsequent growth is tax-free. Roth IRAs don’t make sense in pre-tax investment accounts and they can’t be opened by taxpayers making more than $169,000 (joint returns) or $116,000 (separate returns).
Until now, upper income taxpayers ($100,000 and up) have been prohibited from converting to a Roth IRA. However, the Tax Increase Prevention and Reconciliation Act of 2005 provides a tax planning opportunity for traditional IRA owners in the guise of a revenue enhancement beginning in 2010.
The $100,000 income ceiling for converting a traditional IRA to a Roth IRA will be eliminated for tax years after 2009. Of course, they will have to pay income taxes on their fund balances when they convert.
Additionally, a favorable income inclusion applies to conversions made in 2010 and only to conversion made in 2010. Unless a converting taxpayer elects otherwise, none of the income for a conversion made in 2010 will be taxable for that year; half of the income will be taxable in 2011 and half in 2012.
By extending the right to convert a traditional IRA to a Roth IRA to previously barred high-income taxpayers, and making it easier to pay the tax due on the conversion, Congress expects to garner a short-term revenue windfall as newly eligible taxpayers rush to convert in 2010.
Keep in mind, we don’t know what tax rates will apply in 2011 and 2012 when the ratable inclusions would be made. The tax rates that apply under current law, ranging from 10% to 35%, are scheduled to sunset after 2010, and then be replaced with the rate structure that applied before 2001 (with rates ranging from 15% to 39.6%). Whether Congress will change those rates remains unknown.
The Opportunity
According to a recent survey, only 9% of those surveyed are planning to convert to a Roth IRA in 2010, 73% of Boomers who own an IRA are not planning to convert, 57% of respondents were not even aware that income limits on Roth IRA conversions are scheduled to be eliminated next year, 62% don’t know that the converted funds are subject to tax, and 67% of IRA owners aren’t aware that taxes would be due on converted funds. Of the 33% who know that taxes would be due, 11% don’t realize they can spread the tax bill over 2 years. The need and the opportunity are great.
Advantages to Conversion
Traditionally, deciding whether to convert from a traditional IRA to a Roth required a projection of whether the retiree’s income would be higher or lower in retirement than it is now, a question that isn’t always easy to answer. But, if you and the retiree think the odds are excellent that tax rates across the board are currently low relative to where they could be in the future, a Roth conversion could be an excellent choice; taxpayers should want to take advantage of every means they can to pay taxes now rather than waiting until later.
The Roth IRA also provides more flexibility than a traditional IRA. Notably, there are no mandatory distributions from a Roth at age 70 ½, as is the case with traditional IRA assets. That’s a huge boon for someone who doesn’t expect to need IRA assets during retirement; he or she can allow those investments to grow and pass on a greater amount to heirs.
And while it’s never ideal to tap retirement savings prior to retiring, the Roth is a much better option than a traditional IRA should it become necessary. If five years have elapsed since the Roth conversion, the owner you can withdraw the converted amount, plus any additional contributions, prior to age 59 ½ and won’t have to pay taxes or penalties.
The other compelling argument for an IRA conversion is that it may result in less of a tax hit. By converting to a Roth, the owner will pay tax on any deductible contributions and any investment earnings. If the portfolio has taken a big hit over the past year, the investment-earnings component of the IRA will be way down, which in turn reduces the taxes owed.*
Prime Conversion Candidates
1. In general, the younger the prospect, the more beneficial a conversion will be. That’s because there are more years available to recoup the tax hit.
2. If it’s fairly early in the prospect’s retirement, longevity runs in the family, and the prospect won’t need to access IRA assets for five years or even more, a conversion may well be worth it because there is such a high likelihood of recouping the tax hit.
3. For those who are already retired and taking Social Security, converting to a Roth could reduce the tax owed on Social Security income. Although the conversion could bump up the amount of Social Security benefits that are taxable in the year of the conversion, the conversion could reduce taxes owed in subsequent years. That’s because Roth distributions don’t factor into the calculation that the IRS uses to determine which Social Security benefits are taxable.
4. Those who have primarily made nondeductible contributions in the past are good candidates for a Roth conversion, because they won’t owe taxes on those nondeductible contributions—only investment earnings and deductible contributions will be taxed upon conversion.
5. Those who have amassed a large estate should look at an IRA conversion. Here’s why: (a) the Roth doesn’t require mandatory distributions, thereby allowing assets to compound and increasing the amount which can be passed to a spouse or heirs; (b) because taxes have already been paid on Roth assets, the overall nest egg which can be passed to heirs will be smaller under the estate tax system, and therefore could help to reduce estate-tax liability. (Of course, the estate tax is another issue that will probably be revisited in Washington in the coming years).
6. Finally, for those who are unemployed or whose income is currently appreciably lower than it normally is, it can be advantageous to convert at this juncture. Provided cash is available to pay the tax bill, taxes related to the conversion will be lower than they would be if the taxpayer’s income were higher.
Who Should Think Twice
1. Those that don’t have the money in other assets to pay the tax associated with the conversion.
2. Those younger than 59 ½ and when their only option is to use part of the traditional IRA assets to pay the tax since a 10% early-distribution penalty is owed on any assets not rolled directly into the Roth. Plus, there will be less money at work for retirement.
3. Those who know they’ll be in a significantly lower tax bracket in retirement should think twice about converting.
4. Be careful if it looks like a conversion will push the prospect into a higher tax bracket in the year of conversion. The risk is that the taxpayer could be disqualified for tax benefits, such as credits and deductions, for which he or she would otherwise be eligible.
Other Factors to Consider
1. The longer one lives, the more likely it is that a Roth IRA conversion will make sense. Northwestern Mutual has a Longevity Game that incorporates actuarial data based on health and lifestyle variables and allows one to factor in the life spans of close relatives. The bigger the number produced by this exercise, the better a Roth IRA conversion will look, since the retiree will have more years to enjoy the tax-free use of the Roth investment gains and, of course, more years over which to recover the tax hit taken on the conversion itself.
2. Some investors have placed post-tax dollars into retirement plans, usually because they wanted to take advantage of deferred taxes on investment gains, even though they had exceeded the limits of pre-tax contributions. Any after-tax amounts in retirement programs will not be subject to taxes when upon conversion. The owner will need to add up all retirement account values, calculate the percentage of funds subject to conversion taxes, and make sure the conversion includes at least this percentage of funds. However, the conversion process will be more complicated because federal rules prevent selective conversion of post-tax account values.
3. If this year’s tax rate is likely to sharply drop in the near future, it might make sense to wait to make the conversion. If so, balance that lower tax rate against the prospect that the funds to be converted will have grown in value during the intervening year. Note that the Roth owner will also have to pay the full tax bill in a single year instead of being able to take two years.
You Can Hedge Your Bets
In all of the above situations, you should be aware that clients needn’t convert all of their IRA accounts or even all of any IRA account. Partial conversions are permissible, but the client can’t pick and choose which IRA assets to convert.For example, although it would be advantageous, one can’t convert all of his or her nondeductible IRAs and leave the deductible IRAs intact. Instead, each dollar converted will receive exactly the same tax treatment based on the aggregate breakdown between deductible contributions/ investment earnings and nondeductible contributions within the client’s IRA(s).
Logistics
If a prospect decides not to move forward with a conversion, it pays to double-check with a tax specialist to make sure you’re thinking through all of the variables. And when you do convert, make sure you do it correctly. IRS Publication 590 (Individual Retirement Arrangements) includes all of the details. Be mindful of the deadlines related to conversions too. Taxpayers have until April 15 to make an IRA contribution; the conversion will need to be done by December 31 to count for that tax year.
The Bigger Picture
The IRA rollover opportunity is much bigger and broader than simply Roth conversions:
· Terminated employees can establish a rollover IRA and transfer the 401(k) balance and/or lump sum pension distribution into the rollover IRA account. No income tax is paid on the portion rolled over. In this economic environment, there are many terminated former employees with leftover 401(k) accounts that ought to be rolled over.
· Company sponsored 401(k) plans can have many different distribution options based on the plan documents. Many plans allow employees to rollover significant 401(k) balances while still employed (most often at age 59 ½, but sometimes earlier). Producers who advise prospects about this option and make them clients at that time are in a great position to become and remain the client’s trusted advisor. When that happens and the client’s retirement beckons, competing hordes of producers will descend, but will be too late because of the relationship already established.
· Every year hundreds, perhaps thousands, of the 400,000-plus 401(k) plans in operation are dissolved, for reasons that range from bankruptcy to merger. Although a 401(k) “must be established with the intention of being continued indefinitely,” according to the Internal Revenue Service, sometimes business circumstances can cause a plan to be terminated. Historically, the vast majority of plans that are closed are at small firms, with fewer than 100 participants. However, the current economic crisis has increased the number of plan dissolutions and these dissolutions have not been limited to small plans. Each of these terminations results in opportunities for producers to advise and assist the owners of these 401(k) accounts.
The subject of IRA rollovers is a complex one. Producers must be careful to do the right thing for their clients in this regard. But producers armed with this knowledge will be well-equipped to position themselves as the expert within their community.
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* If you have a loss in your IRA, it’s possible to claim a loss, but it’s not the same as taking a loss in your taxable accounts. You must withdraw all assets from that IRA type, and IRA losses can’t be used directly to offset ordinary income or capital gains. Instead, IRA losses are part of the miscellaneous itemized deductions you claim on schedule A of your form 1040. These deductions must amount to 2% of your adjusted gross income or they won’t be usable.