Planning for Liberalized IRA-to-Roth-IRA Conversion Rules in 2010

Kevin J. Kerrigan, CPA

Next year will be a pivotal one for retirement planning, as it will be the first year in which taxpayers will be able to convert funds in regular IRAs (as well as qualified plan funds) to Roth IRAs regardless of their income level. This new conversion option poses significant tax planning challenges and opportunities for 2009, 2010 and 2011.

Conversions to Roth IRAs.

For 2009, taxpayers (other than married persons filing separately) with modified adjusted gross income (AGI) of $100,000 or less may convert amounts in a traditional IRA to amounts in a Roth IRA. A conversion from a regular IRA to a Roth IRA is subject to tax as if it were distributed from the traditional IRA but isn't subject to the 10% premature distribution tax. After Dec. 31, 2007, distributions from a Code Sec. 401(a) qualified plan also may be rolled over to a Roth IRA.

Major change coming next year.

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 into a Roth IRA (currently they are barred from doing so).

Why make an IRA-to-Roth IRA conversion?

Roth IRAs have two major advantages over regular IRAs:

(1) Distributions from regular IRAs are taxed as ordinary income (except to the extent they represent nondeductible contributions). By contrast, Roth IRA distributions are tax-free if they are “qualified distributions,” that is, if they are made (1) after the 5-tax-year period that begins with the first tax year for which the taxpayer made a contribution to a Roth IRA, and

(2) when the account owner is 59 1/2 years of age or older, or on account of death, disability, or the purchase of a home by a qualified first-time homebuyer (limited to $10,000).

(2) Regular IRAs are subject to the lifetime required minimum distribution (RMD) rules that generally require minimum annual distributions to be made commencing in the year following the year in which the IRA owner attains age 70 1/2. By contrast, Roth IRAs aren't subject to the lifetime RMD rules that apply to regular IRAs (as well as individual account qualified plans).

A similar comparison could be made between distributions from qualified retirement plans and Roth IRAs.

There are other tax advantages: Because distributions from Roth IRAs are tax-free (if they are qualified distributions), they may keep a taxpayer from being taxed in a higher tax bracket that would otherwise apply if he were withdrawing taxable distributions, don't enter into the calculation of tax owed on Social Security payments, and have no effect on AGI-based deductions. What is more, the benefits flow through to beneficiaries of Roth IRA accounts, who also can make tax-free withdrawals from such accounts (they are, however, subject to the same annual post-death minimum distribution rules that apply to beneficiaries of regular IRAs).

Another advantage of a Roth conversion, primarily for high-wealth taxpayers, is that it will reduce one's estate.A Roth conversion is considered a distribution, causing the tax to be paid when a traditional IRA is converted to a Roth IRA. Consequently, a taxpayer's assets and estate are reduced by the tax paid due to the Roth conversion.

Who should make IRA-to-Roth IRA conversions?

Converting some or all of an IRA to a Roth should be considered by everyone but below are three criteria that increase the benefit:

The individual has a number of years to go before retirement (and are therefore able to recoup the dollars that are lost to taxes on account of the conversion);
The individual anticipates being taxed in a higher bracket in the future than they are now; and
The individual can pay the tax on the conversion from non-retirement-account assets (otherwise, there will be a smaller buildup of tax-free earnings in the depleted retirement account).

Complicating factor for 2010 conversions.

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 issue 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 their 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 for those making $250,000, but it is difficult, at this point in time, to predict who will get hit by higher rates. What's more, there are proposals on the table to help finance health reform with a surtax on higher-income taxpayers.

What do to this year?

Taxpayers who intend to take advantage of the new conversion option next year should consider the following strategies:

Non-high-income taxpayers who are able to make deductible IRA contributions this year should do so. They'll reduce their 2009 tax bill and, if they make the conversion to Roth IRA next year, they won't have to pay back the tax savings until 2011 and 2012.
High income taxpayers can increase the conversion amount by making nondeductible IRA contributions this year.
Make the determination in 2009 since a conversion early in 2010 could precede a market up-turn.

For additional information, contact Kevin Kerrigan, Partner at kkerrigan@wiss.com.