You will hear of wars and rumors of wars, and tax increases and rumors of more tax increases to come. Tax year 2010 will offer at least one new tax planning opportunity for moderate to high income taxpayers, however. I seldom recommend that taxpayers pay taxes before they have to, unless it is possible to accelerate income into a year preceding a significant tax increase. Conversion of a traditional individual retirement account (IRA) to a Roth IRA generally triggers income tax in the year of conversion, but may provide estate planning opportunities not available with a traditional IRA.
Under the law applicable to years before 2010, taxpayers with adjusted gross incomes of $100,000 or less may convert a traditional IRA to a Roth IRA. Married taxpayers filing separately, however, may not make such a conversion regardless of their AGIs. Both of these limitations end after 2009. These changes open tax planning opportunities to individuals with moderate or significant retirement account balances who do not need taxable annual mandatory distributions from these plans, or who would rather have flexibility as to the amount they can withdraw each year and do so tax-free. Before looking at the possibilities of a 2010 conversion, let’s review some basic concepts of IRAs.
Traditional IRAs
A traditional IRA is an individual retirement account that grows tax-deferred until the owner of the IRA takes distributions from the account. The full amount of the distribution is taxed. Annual, tax-deductible, contributions to traditional IRAs are limited. These annual contribution limitations do not apply to “rollovers” from other types of retirement plans, however. Many taxpayers chose to “rollover” amounts held in employer qualified retirement plans to traditional IRAs at the time of the taxpayers’ retirement.
Traditional IRA distributions are included in a taxpayer’s gross income in the year of distribution. Distributions prior to the taxpayer reaching age 59-1/2 are subject to a 10% penalty. Traditional IRAs (and most other retirement plans) are subject to annual mandatory distributions upon the taxpayer reaching age 70-1/2. Amounts of the annual mandatory distributions are based on the taxpayer’s age. Theoretically, the IRA would be fully distributed at the taxpayer’s death. The mandatory distribution requirement, therefore, does not permit taxpayers to pass significant IRA account balances to heirs if the taxpayer lives his or her full life expectancy.
Roths
Roth IRAs operate differently. Like traditional IRAs, Roths have annual contribution limitations. Unlike traditionals, however, the contributions are not tax-deductible. Like traditional IRAs, the law permits direct rollovers into Roths from qualified retirement plans. Amounts invested in Roth IRAs grow tax-free, and they are not subject to annual mandatory distributions requirements. All distributions from Roths after age 59-1/2 are tax free. Roth IRAs, therefore, can be accumulated and passed to heirs with no tax impact when they take withdrawals from the account. This eliminates tax on the increase in the account value.
Conversions
Traditional IRAs can be converted to Roths to gain distribution flexibility and the estate planning benefits of the Roth. The cost of conversion is taxation on the amount converted in the year of conversion. While this can seem to be a high price to pay, future distributions to another generation of taxpayers are tax-free. Even though the investment markets have recovered some of their 2009 losses, traditional IRA account balances may still be depressed and attractive for conversion. Conversion has been impossible, however, for taxpayers with adjusted gross income in excess of $100,000 and married taxpayers filing separately.
Planning Opportunity
With these two limitations lifted in 2010, conversion becomes possible for more taxpayers. In addition, traditional IRA account balances converted in 2010 are not subject to tax in that year, but are taken into income in two equal amounts in 2011 and 2012, unless the taxpayer elects otherwise. While tax rates are going to be higher in 2011 and 2012, postponing the tax and paying it over two years may have significant cash flow and “time value of money” benefits. If you currently have substantial balances in former employers’ qualified plan accounts, you can still capitalize on the IRA conversion benefits. While making a direct rollover from a qualified retirement plan to a Roth in 2010 will be permitted, you will forfeit the ability to pay the conversion tax over two years. To avoid loss of this benefit, you should consider creating a traditional IRA now, rolling over the employer account balances, tax-free, to the new IRA in 2009, converting to a Roth in 2010, and paying the tax in 2011 and 2012.
Reconversions
Assume, for a moment, that you make a Roth conversion early in 2010, the market goes south or you otherwise decide the conversion was a bad decision. You’re not dead; you can reconvert the Roth to a traditional IRA prior to October 15, 2010, be essentially back where you started and pay no tax on the failed conversion.
Caveat
Generally, Roth IRA distributions are not taxed if the beneficiary has attained age 59-1/2, at or after the beneficiary’s death, on account of disability, or for certain “first-time home buyers.” Distributions within five year of the contribution or conversion to a Roth are subject to a 10% penalty, however.
Change in tax law
If this is such a good opportunity, why won’t Congress close it in the remaining months of 2009? Roth IRA conversions are revenue generators for the government, because of tax on conversion. With present and looming budget deficits, the fisc is going to need all of the tax revenue it can generate in 2011 and 2012. Eliminating the new conversion opportunity would defer tax on the traditional IRA to future years when the beneficiary takes annual mandatory distributions.
Summary
Traditional to Roth IRA conversions in 2010 offers a one-year tax planning opportunity for moderate to high income tax payers holding moderate or significant account balances in qualified retirement plans or existing IRAs. The decision to convert will require careful planning, some reasonable assumptions regarding future tax rates, the need for distributions from the Roth, and available other resources with which to pay the tax in 2011 and 2012. You should not convert without the assistance of a qualified tax planning professional.
Ronnie
Copyright 2009 Ronnie C. McClure, PhD, CPA
