Roth IRA Conversion. (Frequently Asked Questions) # /10

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1 Roth IRA Conversion (Frequently Asked Questions) # /10

2 The following material is for informational purposes only. It represents a summary of the most common questions asked about Roth IRAs and the answers are not to be construed as recommendations or tax advice but only a conceptual summary of strategic techniques utilizing a Roth IRA. Neither Aviva Life and Annuity Company nor its agents are in the business of providing legal, tax or accounting advice. Please consult with your own professional advisors to learn more about your particular situation and what benefits a Roth IRA can provide you and your family. What is a Roth IRA? A Roth IRA is a special retirement savings account created by Congress to encourage people to save for retirement. Deposits to the Roth IRA are not tax deductible, but if the account is held for the proper length of time all qualified distributions for the account holder and his beneficiaries can be tax-free. An individual may establish a Roth IRA for periodic ongoing deposits or convert an existing retirement account (e.g., a traditional IRA or employer retirement account) to a Roth IRA. What is a Roth IRA Conversion? A Roth IRA conversion is an optional decision to change (convert) an existing tax-favored retirement plan, such as an IRA, SEP, SIMPLE, pension plan, profit-sharing plan, 401(k) or 403(b) into a Roth IRA. To convert the account you must have access to the money in the account (i.e., be able to take a distribution). When the account is converted to a Roth IRA any taxable amount converted becomes reportable as ordinary income in the year of the conversion (a special rule exists for conversions in 2010 that allows the taxable income to be reported over the 2011 and 2012 tax years see the explanation below). Who may convert to a Roth? For all tax years beginning on January 1, 2010, and thereafter, a participant in a tax-favored retirement plan may convert to a Roth IRA regardless of the amount of MAGI (modified adjusted gross income) he or she has. Also, a married couple can convert their retirement accounts, even if they file separate tax returns. These are major changes in Roth IRA regulations and they provide more financial options for middle and upper income taxpayers. Before January 1st, 2010, your modified adjusted gross income had to be $100,000 or less to convert your tax-favored retirement account to a Roth IRA. How is the tax paid on the conversion? A special provision of the new regulations within the Tax Increase Prevention Reconciliation Act of 2005, splits the taxable income from a conversion made in 2010 and reports half of it in 2011 as ordinary income and half of it as ordinary income in In other words if you convert $80,000 from a traditional IRA to a Roth IRA in 2010, your adjusted gross income will increase by $40,000 for 2011 and by $40,000 for No income needs to be reported in The tax for the half reported for 2011 would be due by your tax filing deadline in 2012, and the tax for the half reported in 2012 would be due by your tax filing deadline in 2013, subject to any previous estimated tax payment 1

3 deadlines. If you prefer to have all of the income reported in 2010 because, for example, you have significant offsetting deductions for that year, you may elect to do so. The IRS will provide further guidance on how to make the election to report all of the conversion income in Can I withdraw money from the Roth IRA account after the conversion to pay the taxes? You may withdraw money after the conversion to pay the taxes, but this will impact the advantages the Roth account offers. Money left in the Roth account can accrue earnings that could come out tax free. Therefore, it is usually better to use other funds that are growing in a taxable account to pay the taxes, instead of from the value in the Roth IRA account.. There may also be other consequences for withdrawing money from the Roth account to pay your taxes. If you withdraw money before the end of 2012, and you were going to spread the taxable income over 2011 and 2012, the tax due will be accelerated into the earlier year when the distribution is taken. If you are under age 59 ½ and still within 5 years of the conversion date, a 10% penalty may be applied to the amount withdrawn. Moreover, withdrawing money from your Roth account to cover taxes or other expenses may have a negative impact on your account because it will take longer to recover from the tax hit that resulted from the conversion. It s also important to keep in mind that, if the funding vehicle you chose for the Roth IRA is subject to surrender charges for early withdrawals, those will generally be applicable to the withdrawal you take from the Roth IRA. 2

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5 A Roth IRA conversion is an optional decision to change (convert) an existing tax-favored retirement plan...into a Roth IRA. Why would you elect to report all of the income in 2010 instead of spreading it over 2011 and 2012? The Economic Growth Tax Relief Reconciliation Act of 2001 (EGTRRA) created a system of reducing tax rates. The provisions of EGTRRA sunset after 2010 and tax rates return to the levels they were at before EGTRRA was enacted. You, and your tax advisor, will want to determine if it would be worthwhile for you to elect to report the conversion income in the 2010 tax year -- your total taxes may be lower than if you spread the income over 2011 and You and your tax advisor will need to evaluate the time value of money when determining the best year in which your income should be reported -- waiting until 2011 and 2012 could result in more value because the Roth account could earn income until your taxes are actually due. Why would you convert your taxdeferred retirement account to a Roth and pay the taxes now instead of letting the account continue to grow tax-deferred? There are several reasons you might consider converting to a Roth IRA. Among them are: Tax-free withdrawals for you If a withdrawal from a Roth IRA is a qualified distribution, (defined below), future withdrawals are income-tax free. Legacy of tax-free income for your heirs qualified distributions are also income-tax free for your beneficiaries. This feature can produce years of tax-free income over the lifetime of your heirs. Reducing your taxable estate by paying the income taxes on the conversion now Assets that are used to pay the income taxes due at conversion (and the future earnings on those monies used) are removed from your estate so less value is subject to estate taxation. Income tax-free growth with no RMDs Most tax-favored retirement plans require you to begin taking minimum distributions when you either turn age 70 ½ or retire. Roth IRAs do not have these minimum distribution requirements. Therefore, you can let the Roth IRA continue to grow after age 70 ½. Option to continue contributing after age 70 ½ -- Traditional IRAs do not allow you to make contributions after you turn age 70 ½. Contributions to employer plans must generally cease when you retire. Roth IRAs do not have an age limit beyond which contributions can be made. As long as you have an earned income you can continue to contribute to your Roth IRA. This means that you can continue to grow your Roth account for your heirs. What is a qualified distribution? When a Roth IRA satisfies the requirements needed for a qualified distribution withdrawals from the account, including the earnings, are income-tax free. To be a qualified distribution the account must first be held for 5 years. Additionally, the withdrawal must occur after: 1) the participant reaches age 59 ½; 2) the participant has become disabled; 3) the participant has died and the withdrawal is taken by his or her heirs; or, 4) the participant is using the money in conjunction with the first time purchase of a home (life time maximum of $10,000). 4

6 You can convert to a Roth IRA regardless of your age. Even if you are over age 70 ½ you can convert your account. Are there any age restrictions for converting a tax-favored retirement account to an IRA? No. You can convert to a Roth IRA regardless of your age. Even if you are over age 70½ you can convert your account. Do I have to convert my whole account? No. But, some tax-favored retirement accounts will not permit partial conversions. If the account you want to convert does not have any restrictions regarding partial conversions, you can convert any portion of the account. Only the taxable amount related to the amount converted would be reportable. You will need to work with your tax and legal advisors to determine what amount, if any, would be beneficial for you to convert. You may be able to lessen your total tax burden by converting the amount over several years instead of all at once, because smaller conversion amounts can keep you in a lower tax bracket. However, if you were to die before converting the entire retirement account your heirs would miss out on the opportunity to receive tax-free income from the amount that was not converted. May only the after-tax portion of an IRA be converted? No. If you made a contribution to an IRA that was not deductible because your income limit was too high, you will have money in your account on which taxes have already been paid. Often, this is referred to as after-tax money. You may also have money that was after-tax money that was rolled from a 401(k) plan or thrift plan. When there is both after-tax money and pre-tax money in an IRA a withdrawal must be prorated between the after tax and pre-tax money. If the after-tax money represents 10% of the account, 10% of any amount withdrawn would not be taxable. This rule also applies to any converted amount. If an IRA has after-tax money equal to 10% of the account, 10% of the amount converted would not be taxed and 90% would. Example: Your IRA is valued at $160,000, and $16,000 represents your after-tax contributions. If you convert $40,000, you would report $36,000 (10%, or $4,000, would be a withdrawal of after-tax contributions). It should be noted that if you have a qualified retirement plan (pension, profit-sharing, 401(k), etc.) and you have access to the money, it is possible to remove and convert only the after-tax value of the account. When may a conversion be done for a tax year? You may convert any part of your account at any time during the year, but the conversion must be done by December 31st. You DO NOT have until your tax filing deadline to make the conversion for the previous year. If I am under age 59 ½ when I convert my IRA will I also incur a 10% penalty on the taxable amount? Not as a result of the conversion. Even though the taxable value of the account must be reported, there is no penalty applied at the time of the conversion. However, a withdrawal of the converted amount within the 5 year period following the conversion is subject to the 10% penalty unless an exception applies (e.g., you are over age 59 ½, you are disabled, etc.). 5

7 Are there any amounts in my tax-favored retirement account that I am not allowed to convert? Yes, you are not allowed to convert an amount that is a required minimum distribution. May I convert an IRA account that I inherited from my spouse? Yes. Because you are the spouse you can roll the account to your own IRA account. This allows you to convert the IRA to a Roth IRA in your name. You can then name beneficiaries that can take tax-free income over their life expectancies when they inherit the IRA from you. If you plan to convert the IRA to a Roth at the death of the IRA participant, it might be a good idea to consider life insurance on the life of the IRA participant so there will be money available to pay the income taxes at the time of conversion. May I convert an IRA which I inherited from someone who is not my spouse? No. If you inherited an IRA from someone who was not your spouse you are not eligible to convert the IRA (or other type of tax-favored retirement account) to a Roth IRA. [IRC 401(d)(3)(C)] When can I take withdrawals from my Roth Conversion IRA? Assuming there are no product restrictions that prohibit taking a withdrawal from your Roth IRA, you may take a withdrawal anytime after the conversion. Any gains withdrawn will be subject to income taxation unless you have held the account for more than 5 years and meet the requirements of a qualified distribution (see definition of a qualified distribution above). However, your withdrawal may be subject to penalties on the converted amount if you are still within 5 years of the conversion and no exception applies (e.g., you are over age 59 ½, you are disabled, etc.). What penalty applies to a distribution taken after the conversion, but before age 59 ½? To discourage participants under age 59 ½ from converting to a Roth and then taking a distribution from the conversion amount, Congress instituted a 10% penalty tax on the converted amount for 5 years following the conversion. After 5 years, or at the time an exception (such as age 59 ½) becomes applicable, the converted amount can be withdrawn income-tax free and penalty free. If any gain is withdrawn before age 59 ½ and no 6

8 Assuming there are no product restrictions that prohibit taking a withdrawal from your Roth IRA, you may take a withdrawal anytime after the conversion. exception applies (such as disability), the gain will be subject to income taxation and the penalty tax. For example, an IRA account holder converted her IRA to a Roth at age 45. If she takes a withdrawal at age 52, she will not have to pay the penalty tax on any amount that does not exceed the original amount that was converted and was reported. If she takes any earnings from the account they would be subject to taxation and the penalty because she has not met the definition of a qualified distribution. For Roth IRAs gain comes out after the contributions and conversion amounts so there is no income tax until the contributions and conversion total has been exceeded. How is a distribution taken from the IRA taxed if the conversion occurred after age 59 1/2? Because the amount converted has been reported as taxable income it can be withdrawn tax-free at any time. Also, it is not subject to the 10% penalty because the participant is over age 59 ½. The IRS deems the amount converted to be withdrawn first and once this amount has been withdrawn any additional withdrawals are considered earnings. Until the account has been held for 5 years, any gains withdrawn will be taxable. After 5 years, any gains withdrawn are qualified distributions and are not subject to taxation. If I already have a Roth IRA at the time I convert my account can I apply its 5-year holding period to the converted amount? No. Each conversion starts its own 5-year period. What is the order of distributions from Roth IRAs for determining income taxation? How are distributions from A Roth IRA taxed? The first amounts distributed from a Roth IRA are deemed to be your contributions. The next tier of withdrawals is converted amounts. Earnings are taken after contributions and conversion amounts. If I convert my IRA or retirement account to a Roth can I undo it if I change my mind? You have the right to change your mind. You would move the money from the Roth IRA, by recharacterization, into a traditional IRA. You may either recharacterize the entire conversion amount, or you may recharacterize only a portion of the conversion amount (assuming that the product you have chosen to fund your Roth IRA allows partial recharacterization). The net effect of a recharacterization is that the conversion never occurred. The transfer must be a trustee-to-trustee transfer. Generally, the recharacterization must be made by your tax-filing deadline for the tax year in which the conversion occurred, including extensions. Any earnings on the account since the conversion must also be transferred to the recharacterized IRA account. 7

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10 What is a reconversion? A reconversion is when you convert your IRA or tax-favored retirement account to a Roth IRA, then later recharacterize it back to a traditional IRA, and then re-convert it back to a Roth IRA again. It has been used in times when the market experiences volatility. If you converted your account to the Roth when the market is high you will be required to report the amount converted. It might be in your interest to undo the conversion so you do not pay taxes on the value of the account when it was converted. You would recharacterize the Roth account back to a traditional IRA while the market is low. Then, you could convert the account to a Roth IRA again when the value of the account is lower. The IRS rules limit the time in which a reconversion can take place. (See the next question) If I recharacterize my Roth Conversion IRA to a traditional IRA, may I reconvert it to a Roth IRA again? Yes, you may convert the account but not in the same tax year. You need to wait until January 1st of the next year, or, if later, the 30-day period following the recharacterization. For example, if you recharacterized back to a traditional IRA on June 6th, you would have to wait until January 1st of the next year. But, if you recharacterized on December 20th, you would need to wait until after 30 days has passed. Will I need to take required minimum distributions from my Roth Conversion IRA? No. Roth IRA participants are not subject to required minimum distribution rules. Will my beneficiary(ies) be required to take required minimum distributions after I die? Yes. The beneficiary of your Roth IRA is required to take minimum distributions beginning in the year following your death. The beneficiary can take the proceeds in a lump sum, over a 5-year period ending on December 31st of the year containing the 5th anniversary following your death, or over a period that does not exceed the beneficiary s life expectancy. This enables your beneficiary to stretch the tax-free income over several years. However, if your beneficiary is your spouse, he or she can roll it to his or her own Roth IRA. What factors should be considered in determining if I should convert to a Roth? Each individual s situation will be different. There is no one-size-fits-all rule that can be applied to each taxpayer. For each taxpayer a variety of factors need to be considered. Among them are: How many years before you will take distributions The longer the time frame before distributions start, the longer you have to recover from the initial tax hit. Your tax bracket in future years If your tax bracket is expected to be higher when you retire, a conversion might provide more net income in future years than the traditional account would have provided. How will taxes be paid on the conversion Usually it is better to pay the taxes from another nonqualified source. Because money in the Roth IRA is tax-deferred, and maybe tax-free, it should grow faster and provide more income than an account that is not tax-deferred or tax-free. 9

11 Each individual s situation will be different. There is no one-size-fits-all rule that can be applied to each taxpayer. For each taxpayer a variety of factors need to be considered. Will your heirs stretch the pay outs or take a lump sum If your heirs will take payments over their life expectancies the total tax-free income they may receive could be significant. If your heirs plan to take the proceeds in a lump sum rather than an income stream the net amount your heirs receive could be less than the original account value if enough time has not passed to recover from the tax hit. To offer the heirs the option of taking the lump sum, a term insurance policy could cover the tax hit if death occurs within a short period after the conversion. Your current tax bracket Would it be better to do partial conversions to stay in a lower tax bracket? If you convert smaller amounts you may be able to keep your tax bracket lower so the tax impact will not be as severe. The disadvantage is that any amount that has not been converted when you die will not be taxfree income for your heirs. Is creditor protection better for the existing account than for the Roth If you have a risk of litigation in your future it might be better to stay in the existing account. Some accounts, such as pension, profit sharing, 401(k)s, SEPs and SIMPLEs have unlimited bankruptcy protection. Roth IRAs have bankruptcy protection up to $1,000,000, and other creditor protections vary by states. So, by moving the money from a pension or 401(k) the amount of your bankruptcy protection could be reduced if the total account value is more than $1,000,000. What, if any, is the estate tax exposure? The value of your Roth account will also be included in your estate, just like the existing retirement account. Since you will incur taxation upon conversion to a Roth, there may be other alternative solutions to consider. Perhaps withdrawal of money from the retirement account with corresponding gifts into an irrevocable life insurance trust to buy life insurance will provide more estate tax free and income tax free money for your heirs. Again, assistance from your tax and legal advisors should be sought to determine if there are better solutions. Effect on my child s ability to qualify for college scholarships or grants? The year in which the conversion occurs, your adjusted gross income will increase by any taxable amount. Since this figure will be reported on financial assistance papers with colleges it could impact your child s eligibility for assistance. Effect of conversion on Social Security payments If you are receiving social security payments the reportable amount from the conversion could cause some or all of your social security payments to be taxable in that year. Your tax advisors should be consulted regarding this impact. Effect of conversion on Medicare premiums your conversion will increase your adjusted gross income. This could cause your Medicare premiums to increase a little in subsequent years. Of course many factors will impact your decision to convert such as your financial situation, age, tax bracket, current assets and alternate sources of retirement income. Your unique circumstances help determine what s right for you. Be sure to involve your tax and legal advisors in making this important decision with long-term impact on you and your heirs. 10

12 We are honored that you ve put your trust in Aviva. We won t let you down. As you read this, thousands of Aviva associates are focused on our three-letter mission statement: You We re making business and investment decisions that will ensure we can meet our obligations to you and your loved ones. We re developing new ways to provide better service to you. We re challenging ourselves to reinvent the way we look at life insurance and annuities, so we can continue to meet the financial needs of a changing world your world. Most of all, we re drawing on the experience of our parent company, Aviva plc, with their more than 300-year legacy. As the oldest continuously operating insurance group in the world, Aviva has endured and thrived through centuries of war and peace, booms and recessions and constant change. The highs and lows have taught us to be prepared so you can count on us, especially during times of uncertainty. We never forget that our business is about the people we insure. It s about you. We want to help you achieve peace of mind and prosperity with Aviva. You can count on us to be here when you need us. Neither Aviva nor its agents give legal or tax advice. You should always seek the opinion of your own legal or tax advisor prior to any transaction. Information presented is based on our understanding of current tax laws and regulations, which is subject to change. In order to comply with certain U.S. Treasury regulations, please be advised of the following: Unless expressly stated otherwise, any U.S. Federal tax advice contained in these materials, including attachments, is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed by the Internal Revenue Service. Aviva Life and Annuity Company 7700 Mills Civic Parkway West Des Moines, IA Aviva Life and Annuity Company of New York Mail Processing Center: P.O. Box Des Moines, IA Home Office: Melville, NY # /10

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