Roth IRA Conversions: Is The Time Right?

There’s a new tax-saving opportunity this year for affluent taxpayers. That’s because the income limit for converting a traditional IRA to a Roth account has been eliminated. Here is a rundown of the new rules, as well as the advantages of converting and the factors you should consider before making a decision.

EVALUATE RELEVANT FACTORS BEFORE CONVERTING

For many taxpayers, the opportunity to make a Roth IRA conversion is finally here. Beginning in 2010, you can convert a traditional IRA to a Roth, regardless of your income. Prior to 2010, such a conversion was allowed only in a year in which your modified adjusted gross income (MAGI) didn’t exceed $100,000.

The elimination of the $100,000 dollar cap was actually part of the Tax Increase and Prevention Reconciliation Act, which was enacted in 2006, so we waited four years for this opportunity to kick in.

Deal Sweetener: For federal tax purposes, with a 2010 conversion, you can choose to spread the resulting taxable income evenly over 2011 and 2012 and thereby defer the related taxes.

But converting to a Roth isn’t always a slam-dunk decision. There are a number of important variables to take into account.

Let’s start with the main advantages of converting a traditional IRA, including a SEP or SIMPLE IRA, into a Roth IRA.

Unlike withdrawals from traditional IRAs, qualifying Roth withdrawals are free of federal income taxes and usually state income taxes too. Generally, qualifying withdrawals involve those taken after you’ve had at least one Roth account open for more than five years and you reach age 59 1/2.

Future income and gains earned in the Roth account are allowed to accumulate federal-income-tax-free.

Roth account owners who reach age 70 1/2 don’t have to take the required minimum distributions that must be withdrawn from traditional IRAs. So you can leave a Roth balance untouched for as long as you live. This makes a Roth an ideal asset to leave to heirs if you don’t need the money yourself.

Another great feature about Roth conversions is you can change your mind. You have until October 15 of the year following the conversion year to “recharacterize” the converted account back to traditional IRA status. This amounts to reversing the earlier conversion.

Here are a few factors to evaluate when considering a conversion:

Even if you can defer the tax owed on a conversion, you should pay for it out-of-pocket. Of course, this could siphon off funds needed for other purposes. But if you’re forced to use assets in a traditional IRA for the tax payments, it dilutes the overall benefit.

The extra taxable income triggered by a conversion is added to your salary, self-employment earnings, investment income, and so forth. So if you convert a large-balance IRA, it could bump you into a higher tax bracket and make you ineligible for some tax breaks, such as the child and education tax credits and passive loss deductions from investment real estate.

If you begin taking funds out of a Roth IRA before you reach age 59 1/2, and the withdrawals are not covered by one of the qualified exceptions, you will generally have to pay a 10 percent early withdrawal penalty.

Don’t forget to include state income taxes in the calculation.

Other factors can play a major role in your decision. These include the investment return on assets, your projected life expectancy (and the life expectancies of your heirs), your current tax rate, the likelihood of increasing tax rates and the value of the assets being converted.

Be aware that a conversion doesn’t have to be an all-or-nothing proposition. You can convert as much or as little as you like. Frequently, a partial conversion may be the optimal approach.

Important: Although the income restriction for converting has been lifted for 2010, the income limits for annual Roth IRA contributions are still in place. For example, you can make a contribution for 2010 of up to $5,000 ($6,000 if you are age 50 on December 31, 2010). But once your MAGI exceeds $166,000 for married couples filing jointly ($105,000 for singles), the amount you can contribute goes down or “phases out.” You are no longer eligible to contribute to a 2010 Roth if your MAGI exceeds $176,000 for married couples ($120,000 for singles). So in 2010, you might be able to convert a traditional IRA to a Roth if your income is $200,000 or more, but you won’t be able to make an annual contribution to one.

Finally: There’s no substitute for expert advice. Although online conversion calculators are available, they may omit critical factors or base projections on unsubstantiated assumptions. Your tax adviser can help you make a sound decision using all the available data.

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DIRECT 401(K)-TO-ROTH ROLLOVERS

Years ago, if you wanted to convert assets in a 401(k) plan to a Roth, you had to make two moves. First, you had to roll over the 401(k) assets to a traditional IRA. Then, you had to convert the IRA to a Roth.

But the Pension Protection Act of 2006 authorized direct rollovers from qualified plans, such as 401(k)s, to Roth IRAs.

Now that the $100,000 dollar cap has been removed, you might take advantage of the 401(k) change. The IRS issued guidance in Notice 2009-75 on this technique. Here are a few key points:

If you roll over assets from a designated Roth-401(k), the amount rolled over isn’t taxable, regardless of whether it constitutes a qualified distribution or not.

Other transfers are subject to tax. The taxable amount is equal to the amount transferred to the Roth reduced by any after-tax contributions.

Special rules apply to net unrealized appreciation of company stock in a plan account. A plan participant generally does not owe tax on this appreciation when it is distributed. The IRS Notice clarifies that tax on net unrealized appreciation can’t be avoided in a direct rollover to a Roth IRA.

BUSINESS WISDOM FOR TODAY’S ECONOMY

“Anyone may arrange his affairs so that his taxes shall be as low as possible … nobody owes any public duty to pay more than the law demands.”

– U.S. Court of Appeals Judge Learned Hand (1872-1961)