Roth IRAs enjoy certain tax attributes when compared to traditional IRAs. The most obvious is that, unlike traditional IRAs, distributions from Roth IRAs are received tax-free as long as the funds have been in the Roth for at least five years and there is no minimum required distribution at age 70 1/2. The disadvantage of Roth IRAs is that, unlike tradional IRAs, contributions to Roth IRAs are not tax deductible. Moreover, for 2009 single taxpayers and married taxpayers filing separately with modified adjusted gross incomes from $105,000 to $120,000 and married taxpayers filing jointly with modified adjusted gross income from $166,000 to $176,000 have their allowable contribution to Roth IRAs phased out.
2010 will be a pivotal year for retirement planning, as it will be the first year in which taxpayers will be able to convert funds in regular IRAs to Roth IRAs regardless of their income level. For tax years beginning after 2009, the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated. Additionally, married taxpayers filing a separate return will be able to convert amounts in a traditional IRA to a Roth IRA.
A unique income inclusion rule will apply for IRA-to-Roth IRA conversions occurring in 2010. Unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012.
A major wild card in making this choice is the tax-rate picture after 2010. Absent Congressional action, after 2010 the tax brackets above the 15% bracket will revert to pre-2001 levels. That means the top four brackets will be 39.6%, 36%, 31% and 28%, instead of the current top four brackets of 35%, 33%, 28% and 25%. The Administration has proposed to increase taxes only on those making $250,000 and up, but it is difficult to predict who will get hit with the higher rates.
Taxpayers who intend to take advantage of the new Roth IRA conversion option in 2010 should consider the following year-end 2009 strategies:
1) Non-high income taxpayers who are able to make deductible traditional IRA contributions should do so. They will thereby reduce their 2009 tax bill and not have to pay back the tax savings until 2011 and 2012.
2) High income taxpayers should consider making non-deductible IRA contributions in 2009. The conversion is generally taxable only to the extent of the earnings on the non-deductible contributions.
3) High income taxpayers who plan on making large conversions in 2010 but who will opt out of the deferral of tax to 2011 and 2012 because they anticipate higher tax rates in those years should try to accelerate income to 2009 and defer deductions to 2010. This is contrary to the usual thinking but will help avoid being pushed into the highest brackets by a large IRA-to-Roth IRA conversion.
A taxpayer who elects to convert all or a portion of their traditional IRA to a Roth IRA should always pay the tax resulting from the conversion from funds other than the IRA. Thus, a high net worth individual is reducing his or her taxable estate by the amount of the tax paid due to the conversion. Naturally, the trade-off is that the tax money paid is no longer available for investment.
Losses on investments held within a Roth IRA are not recognized when the losses occur, however, when a taxpayer liquidates all of his or her Roth IRAs a loss is recognized if the amounts distributed are less than the unrecovered basis. Unrecovered basis includes regular and conversion contributions, all of which are non-deductible contributions. The recognized loss is an ordinary loss but can only be claimed as a miscellaneous itemized deduction subject to the 2%-of-AGI floor.
There exists an additional tax trap for taxpayers who make a conversion from a traditional IRA to a Roth IRA. A 10% premature withdrawal penalty is imposed if converted amounts are withdrawn from the Roth IRA within five years. The 10% penalty does not apply if the taxpayer has reached age 59 1/2, or has sufficient higher education expenses, or has up to $10,000 of first-time homebuyer expenses, or has to pay certain medical expenses.
An interesting regulation allows a taxpayer who has made an IRA-to-Roth IRA conversion in 2010 to "undo" the conversion within nine months. Thus, should a taxpayer suffer a substantial reduction in the value of the converted IRA, he or she could reverse the conversion and avoid paying tax on a converted amount that no longer exists.
We have attempted to cover the highlights of the liberalized IRA-to-Roth IRA conversion rules in this letter. However, we realize the need to seek expert advice in negotiating through the twists and turns of these rules as well as many of the complexities of the tax code. We welcome your calls and look forward to providing answers to your tax queries.
