IRA CONVERSIONS: TRADITIONAL TO ROTH

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1 IRA CONVERSIONS: TRADITIONAL TO ROTH I had planned to continue last month s discussion regarding informational returns in this November, 2010 FlashPoints. However, I have decided to defer that to next month and, instead, discuss a more time sensitive topic, IRA conversions. A Brief History of IRA s: The traditional Individual Retirement Account ( IRA ) was created as part of the Employee Retirement Income Security Act of At the time, IRA s were only available to taxpayers who were not covered by a pension plan. In 1981, the Economic Recovery Tax Act of 1981 loosened the rules to allow taxpayers to contribute even if they were covered by pension plans. Over the years, the Federal Income Tax laws governing IRA s have expanded to a number of variations on the IRA. One of the more significant expansions the Roth IRA, enacted as part of the Taxpayer Relief Act of IRA s are among the most common income tax vehicles that people have. For many taxpayers, IRA s represent the largest asset that they own. A Brief Explanation of Traditional and Roth IRA s: 1. Traditional IRA s: Here are the basic features of a Traditional IRA: If they qualify, taxpayers may contribute to a Traditional IRA account and take a deduction on their Individual Income Tax Returns (Form 1040). The determination as to how much may be contributed and whether it is deductible is made based upon a combination of factors including: how much compensation or earned income they had in a particular year, whether they (or their spouse if they are married) are covered by a pension plan; what their income levels are, and their age. Once the contribution is made (whether or not it was deductible) the Traditional IRA earns money tax free. Money taken out of a Traditional IRA is subject to income tax. There is no distinction make between what was contributed and what was earned. However, if a taxpayers made contributions that were not deductible ( Nondeductible IRA Contributions ), then they are allowed to calculate a portion of the withdrawal 1

2 attributable to the Nondeductible IRA Contributions as not being subject to income tax upon withdrawal. If a taxpayer takes a withdrawal from a Traditional IRA before they turn age 59-1/2, then, the taxpayer must also pay a 10% penalty. There is a short list of exceptions where the 10% penalty may not apply even if the taxpayer is under age 59-1/2. While the tax laws encourage taxpayers, through income tax incentives, to contribute to IRA s the Federal government still wants a bite at the apple. Upon the first occurrence of certain life events, the tax laws require that taxpayers begin withdrawing money from their IRA s, whether or not the taxpayer wants to make a withdrawal. These are referred to as the Minimum Distribution Rules. The 2 most common life events triggering Minimum Distributions are the taxpayer reaching age 70-1/2 and the death of a taxpayer (where the beneficiary is not the taxpayers surviving spouse). Once a taxpayer turns age 70-1/2, they can no longer make contributions to a Traditional IRA account. IRA s are included in the estate of the taxpayer, for Estate Tax purposes based upon the Fair Market Value ( FMV ) at the time of the taxpayer s death. 2. Roth IRA s: Roth IRA s are similar to Traditional IRA s in many ways. Here is a brief summary of how Roth IRA s are different from Traditional IRA s: Taxpayers are not allowed to deduct Roth IRA contributions. Taxpayers are not subject to the Minimum Distribution Rules. That is, they are not required to withdraw from a Roth IRA. Surviving spouses who inherit Roth IRA s are also not subject to the Minimum Distribution Rules (alas, non-spouse beneficiaries of Roth IRA s are subject to the Minimum Distribution Rules). Withdrawals from a Roth IRA are not subject to income tax so long as the withdrawal is made at least 5 years after contribution and the taxpayer is at least age 59-1/2 or disabled or died (there is also a limited exception for first-time home buyers). There is no age restriction on contributions. To the extent that they otherwise qualify, taxpayers are not barred from making contributions to Roth IRA account just because they turn age 70-1/2. 2

3 Converting From a Traditional IRA to a Roth IRA: The Federal Income Tax laws allow/encourage taxpayers to convert Traditional IRA s into Roth IRA s. The laws were recently changed to allow more people to convert and even give taxpayers a 1-time incentive to convert in All things being equal, taxpayers would rather be holding a Roth IRA than a Traditional IRA. So why is the Federal Government being so nice? The catch is that there will be a toll charge. The Federal Government is hoping that many taxpayers take advantage so that the U.S. Treasury can get the windfall of income tax payments resulting from the conversions. Prior to 2010: Prior to 2010, the Federal Income tax laws allowed only certain taxpayers, if they qualified, to convert their Traditional IRA s to Roth IRA s. To qualify: 1. A taxpayer s modified Adjusted Gross Income ( AGI ) had to have been $100,000 or less; and 2. The taxpayer did not file their tax return as Married Filing Separately. For 2010 and Future Years: The Federal Income tax laws were changed to allow all taxpayers the opportunity to convert their Traditional IRA s to Roth IRA s. Beginning in 2010, taxpayers can convert their Traditional IRA s to Roth IRA s regardless of their modified AGI and regardless of their filing status. Accordingly, for the first time, all taxpayers may convert their Traditional IRA s to Roth IRA s. Keep in mind, the taxpayers that were previously unable to convert were generally those at higher income levels. If they are at higher income levels, they also had income taxed at higher tax rates. Allowing these taxpayers to convert means that the IRS is not only getting more people to convert, but people whose income will be taxed at higher rates. For 2010 Only: To the extent that a taxpayer converts in 2010, they have a choice as to when they report the income resulting from the conversion. Here are their choices: 1. Include all of the income on their 2010 Returns; or 3

4 2. Include nothing on their 2010 Return and then include 50% on their 2011 Return and 50% on their 2012 Return. The Federal Government seems to have taken a page out of the classic infomercial come on: and if you act now... Here are some other rules to be aware of at any time that you are considering a conversion: 1. You can only convert your own Traditional IRAs. A spouse can inherit an IRA and treat it as their own, in which case it can be converted. However, no one other than a surviving spouse can convert an inherited IRA. 2. Special calculations can be made that could reduce the taxable income resulting from a conversion from a Traditional IRA that has some non-deductible contributions. 3. If you have a 401K, you may be able to roll/convert that directly into a Roth IRA. You should check with your 401K plan administrator. 4. Conversions are not all or nothing. You can convert part or all of your Traditional IRA s. Further, if you are married, one spouse can convert while the other does not. If you have more than one Traditional IRA, you can convert some and not others. However, if you have made any nondeductible Traditional IRA contributions, you cannot cherry-pick just that portion to convert. In that situation, you must convert pro-rata from among all Traditional IRA s. These calculations could get tricky. 5. The 10% early withdrawal penalty does not apply to valid conversions. To Convert or Not to Convert, That is The Question: Many taxpayers have been able to convert their Traditional IRA s into Roth IRA s for years. However, 2010 presents the first opportunity for certain higher income taxpayers to convert their Traditional IRA s into Roth IRA s and the only time for any taxpayer to get a 2-year spread on reporting the income. This has caused a lot of buzz. 4

5 Should a taxpayer convert? If so, how much should they convert? If they convert, should they report the income in 2010 or spread it over 2011 and 2012? The answer to each of these questions is: It depends. Here are some key factors to consider: 1. What is the income tax cost of the conversion? Income tax rates are graduated, the higher the taxable income, the higher the tax rate that is applied to that income. In general, as your taxable income increases, the tax bite becomes increasingly large. However, there is more to a tax cost than the tax rates. For example: Your filing status affects how soon taxable income hits the higher tax rates and how many exemptions you are entitled to take. If your filing status will be changing, that change may impact the tax cost. Alternative Minimum Tax ( AMT ) affects more and more taxpayers. If you are subject to AMT, the increased income resulting from a conversion may not result in as much an increase in your tax as it would if you were not subject to AMT. If your income fluctuates (apart from IRA conversions) then including income from a conversion in a year of higher income from other sources may result in pushing more income into a higher tax rate. If your deductions fluctuate (or you can control the timing of certain deductions) then including income from a conversion in a year of higher deductions may not result in higher tax. 2. Do you have sufficient assets outside of the IRA to pay the tax? If you do not have sufficient non-ira assets to pay the tax, you would have to take a withdrawal from an IRA in order to pay the tax. This would also be included in your income. For some taxpayers, this could also be subject to the additional 10% early withdrawal penalty. You would also be left with that much less invested in your tax deferred IRA vehicle. 3. What is the income tax cost of taking distributions and not converting? Of course, there is no income tax cost of leaving assets in an IRA. However, if you felt that you income would be higher in future years, or that the tax rates would be dramatically higher in future years, then the tax cost of taking money from a Traditional IRA in later years could be higher than converting. 5

6 4. What will the rate of growth be on my assets? The faster the Roth IRA grows, the more income that will be earned free of tax (while in the IRA and upon removal). Fast growth, while in a Roth IRA, will make the overall cost of converting less significant. 5. What is the opportunity cost? If you pay a tax, you have less money for other things. 6. How does it make you feel? For some people, there is a psychological impact. When they look at their financial statements, it makes them feel bad and/or less secure if the balance is smaller. 7. How long will the assets remain in the IRA? A conversion makes more sense if you are planning not to need the money from the IRA. For example, if you plan to take money from your Traditional IRA each year to use and spend anyway, the fact that the Minimum Distribution Rules will require that you take money from a Traditional IRA has less of an impact on you. Further, the sooner you plan to use the money from an IRA, the less time the Roth IRA will have to grow, tax free. A factor in determining how long assets will remain in the IRA may be how long you will live. Another is whether you will have years for which large sums of money will be required to take care of you (whether in a nursing home or in-home care) and whether you will need to draw down IRA s to pay for these costs. 8. Estate Planning Tool: Both Traditional and Roth IRA s are counted the same way in determining one s taxable estate for Estate Tax purposes. However, a surviving spouse can take over a Roth as their own and never have to take distributions. Further, even a non-spouse beneficiary will get the benefit of being able to take distributions free of income tax. This may provide some estate planning opportunities. 9. State Tax laws: In Illinois, and for many states, the income from a conversion is not subject to state income tax. 6

7 Conclusion: The law now allows higher income taxpayers the ability to convert their Traditional IRA s into Roth IRA s. Further, all taxpayers have a 1-time opportunity to defer the recognition of income to the extent that they convert in 2010 (50% in 2011 and 50% in 2012). There is no single answer that is right for everyone. For most, a careful analysis should be performed with input from their tax advisor and financial advisor. Even with a careful analysis, each taxpayer must make certain assumptions about the future (e.g. how long will they live, will they need the money, how will their investments perform, what will tax rates be, etc.) Keep in mind, if you want to qualify for the 1-time deferral of income recognition, you must convert your Traditional IRA to a Roth IRA by the end of the day on December 31, In the next issue of Tax Law Explained, we will explore the Schedule K-1 reporting requirements of S Corporations, Partnerships, LLC s (taxed as Partnerships or S Corporations), Trusts and Estates. 11/2010 Copyright, Keith B. Baker This article is designed to be a public resource of general information. It does not constitute legal advice nor does it create a client-attorney relationship. While the information is intended to be accurate, this cannot be guaranteed. Tax laws are complex and constantly changing as a result of new laws, regulations, court interpretations and IRS pronouncements. Often, there are also various possible interpretations. Further, the applicable rules can be affected by the facts and circumstances of a particular situation. Because of this, some of the information may no longer be correct or may not apply to all situations. We are not responsible for any consequences or losses resulting from your reliance on such information. You are urged to consult an experienced lawyer concerning your particular factual situation and any specific legal questions you may have. IRS Circular 230 Disclosure: Any discussion of federal tax issues in this correspondence may constitute "written tax advice". Any such advice is limited to the issues specifically addressed, and the conclusions expressed may be affected by additional considerations not addressed herein. Any tax information or written tax advice contained herein (including any attachments) is not intended to be, and cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed 7

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