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Update from ATG Trust Company

Factors to Consider

Before 2010, taxpayers with a modified adjusted gross income (MAGI) in excess of $100,000, or who filed their federal income tax returns using the Married Filing Separately filing status, were prohibited from converting a traditional IRA to a Roth IRA. In 2010, however, these prohibitions no longer apply. For many individuals, the ability to convert a traditional IRA to a Roth IRA represents a significant tax planning opportunity.

Pay Me Later or Pay Me Now

With a traditional IRA, and assuming certain requirements are met, contributions are deductible in the year they are made. The tax due on the contributions, and the tax due on any earnings or growth, is deferred until funds are distributed from the account, typically at retirement. From an income tax perspective, this is a "pay me later" scenario.

With a Roth IRA, contributions are never deductible; contributions are made with funds that have already been taxed. If certain requirements are met, both the contributions and any earnings or growth are received income-tax free when withdrawn from the account. From an income tax perspective, this is a "pay me now" scenario.

A taxpayer who elects to convert a traditional IRA to a Roth IRA has chosen to pay the income tax now rather than waiting until the future to pay it. To justify a conversion, the benefit of not paying taxes tomorrow should be greater than the cost of paying taxes today.

Benefits of Roth IRAs

The benefits of holding assets in a Roth IRA can be considerable:

• During Life - Tax-Free Income | After a Roth IRA has been in existence for five-years, and assuming certain other requirements are met, "qualified" distributions from the account are received income-tax free.

 

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• At Death - Tax-Free Income to Beneficiaries | At death, Roth IRA proceeds are includable in the account owner's estate and are subject to federal estate tax. For non- spousal beneficiaries, and assuming that the five-year waiting period requirement has been met, the proceeds are received income-tax free. After the owner's death, however, non-spousal beneficiaries must take certain required minimum distributions from the account. A surviving spouse can treat an inherited Roth IRA as his or her own, with the proceeds being received income-tax free, and with no required minimum distributions.

 

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• No Lifetime Required Minimum Distributions | Federal income tax law mandates that certain required minimum distributions be made from traditional IRAs, beginning when the account owner reaches age 70 1/2. For Roth IRAs, there are no minimum distribution requirements during the lifetime of the account owner.

 

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• Contributions after Age 70 1/2 | As long as a taxpayer has "compensation" (such as wages or self-employment income), contributions may be made to a Roth IRA regardless of the taxpayer's age, subject to the Roth income and filing status limitations. No contributions are permitted to a traditional IRA after the owner reaches age 70 1/2.

The Cost of Conversion

Converting a traditional IRA to a Roth IRA is a currently taxable event. For the year of conversion, the taxpayer must include in gross income all previously deducted contributions, plus net earnings (or minus net losses). For individual retirement annuities, gross income is increased by the fair market value of the contract on the date of distribution. Any 10% penalty tax for early withdrawals is waived.

For conversions completed in 2010, a taxpayer may choose to include 50% of the taxable amount in gross income in 2011 and 50% in 2012. If this option is chosen, the additional income will be taxed at the marginal income tax rates in effect in those years. Alternatively, a taxpayer may choose to include 100% of the taxable income from the conversion in 2010's gross income, taxable at the marginal rates in effect in 2010.

For any other year besides 2010, all of the taxable income from the conversion is included in gross income in the year the conversion is completed.

If a taxpayer has traditional IRA accounts that hold both deductible and non-deductible amounts, he or she may not "cherry-pick" and roll over only the non-deductible contributions. Instead, the value of all IRA accounts is added together and a ratio is calculated to determine the tax-free portion of any rollover.

Example: Paul has a traditional IRA to which he has made $20,000 in non-deductible contributions. This year, when he converts the account to a Roth IRA, the balance is this IRA is $30,000. Paul also has a separate IRA containing $70,000 in deductible contributions from a 401(k) plan with a previous employer. The total value of both accounts is $100,000. His "non-deductible" ratio is thus 20%, ($20,000 ÷ $100,000). When Paul converts the $30,000 in his non-deductible IRA, he may exclude only $6,000 (20% x $30,000) from gross income. The remaining $24,000 ($30,000 - $6,000) is includable in his gross income, subject to tax.

Situations Favoring Conversion to a Roth IRA

Situations where conversion may be beneficial include the following:

• Small Account Values | If the dollar amount in the traditional IRA is small, the income-tax cost to convert today would be relatively low.

 

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• Longer Time to Retirement | A longer period of time until retirement allows for greater future growth, necessary to recoup the up-front cost of paying the tax now.

 

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• Cash to Pay the Taxes | Where will the money come from to pay the extra taxes? It's usually better if the account owner has sufficient cash outside of the IRA to pay the tax. Could the funds used to pay the tax today provide a greater return if invested elsewhere?

 

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• IRA Income Not Needed | Some individuals have adequate retirement income from other sources, so that IRA monies are not needed to fund retirement. During the lifetime of the account owner, a Roth IRA has no minimum distribution requirements.

 

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• Higher Future Tax Bracket | If a taxpayer anticipates being in a higher tax bracket in the future, paying the tax today, at lower rates, is a logical step. Being taxed at a higher marginal rate may be the result of legislative changes, having a higher taxable income, or a change in filing status, such as when couple divorce or a spouse dies.

Situations NOT Favoring Conversion to a Roth IRA

In some situations, converting a traditional IRA to a Roth IRA may not be appropriate:

• Retirement Begins Soon | If there is only a short time before retirement begins, there may not be enough time for future growth to offset the cost of paying the tax today.

 

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• High IRA Account Values | If the dollar amount in the traditional IRA is large, the tax bill resulting from the conversion will likely be expensive; the conversion could push a taxpayer into a higher marginal tax bracket or make Social Security benefits taxable.

 

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• No Cash to Pay the Taxes | A taxpayer may not have the cash outside the IRA to pay the extra tax that results from the conversion. Taking funds from the IRA to pay the increased tax reduces the amount left in the account to grow into the future. If the account owner is under age 59 1/2 at the time these extra funds are withdrawn from the IRA, a 10% penalty on the amount not converted will likely be added to the tax bill.

 

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• Lower Future Tax Rates | If a taxpayer anticipates being in a lower tax bracket in the future, paying the tax today, at higher marginal tax rates, makes no sense at all.

Recharacterization

After converting a traditional IRA to a Roth IRA, a taxpayer may find that the conversion was a mistake. Federal income tax law provides for "undoing" the conversion, a process known as "recharacterization." However, strict rules apply to the recharacterization process and these must be carefully followed.

Seek Professional Guidance

The decision to convert all or part of a traditional IRA to a Roth IRA is an individual one. A thorough analysis requires careful consideration of a number of income tax, investment, and estate planning factors, over an extended time horizon. The advice and guidance of appropriate financial, tax, and investment professionals is strongly recommended.

For lawyers advising their estate planning clients, feel free to contact us about how ATG Trust can assist with the IRA conversion process, or other services related to investment planning.

ATG Trust Company provides lawyers and their clients with trust, estate, investment, and Section 1031 Exchange services. Contact us for more information: 877.674.7878 or info@atgtrust.com.

THE TRUSTED ADVISER is published by Attorneys’ Title Guaranty Fund, Inc., P.O. Box 9136, Champaign, IL 61826-9136. Inquiries may be made directly to Mary Beth McCarthy, Corporate Communications Manager. ATG®, ATG® plus logo, are marks of Attorneys’ Title Guaranty Fund, Inc. and are registered in the U.S. Patent and Trademark Office. The contents of the The Trusted Adviser © Attorneys' Title Guaranty Fund, Inc.

[Last update: 2-22-10]