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Reassessing Roth IRAs: 2010 Presents a One-Time Opportunity from the IRS

December 2009

On January 1, 2010, higher income taxpayers will have access to a powerful retirement and estate planning vehicle offered under the Internal Revenue Code. For the first time, Roth IRAs will effectively be available to all taxpayers, regardless of their income level. Moreover, those taxpayers who take advantage of this new opportunity before the end of 2010 will be rewarded with several additional benefits.

Roth IRAs allow wealth to grow tax-free for a longer period of time. They also offer: the absence of required minimum distributions; the ability to continue contributing funds after attaining the age of 70 ½; and tax-free withdrawals. By far the greatest benefit of Roth IRAs is that they enhance the ultimate payout to the taxpayer and/or their beneficiaries.

Currently, high income earners with modified adjusted gross incomes above $166,000, if filing jointly, or $105,000, if filing individually, have limited or no access to Roth IRAs through either contributions or conversions (i.e., transferring assets from a non-Roth IRA into a Roth IRA).

After December 31, 2009, the income limits for conversions will be removed and therefore all taxpayers will be eligible to convert certain retirement plans into Roth IRAs, including: traditional IRAs; SEP IRAs; SIMPLE IRAs; 401(a) qualified plans; 401(k)s; 403(a) annuity plans; 403(b) annuity plans; and 457(b) plans. The immediate consequence of any conversion to a Roth IRA is that the converted sum is taxed as income in the tax year of conversion. Certainly, this creates an increased tax burden. However, under the new tax rules, anyone who chooses to convert their existing retirement vehicle in 2010 will have the option to spread the income between 2011 and 2012, and pay tax on one-half of the entire amount in each of those two years.

For example, if a traditional IRA owner converts $50,000 into a Roth IRA in 2010, the owner will not report any income in 2010, but rather $25,000 of income in each of 2011 and 2012. Thus, that tax will be deferred until 2012 and 2013. Alternatively, the owner may opt to report the entire $50,000 in 2010. This might present a planning opportunity because the due date for the 2010 extended income tax return is October 15, 2011, when the subsequent tax year’s income tax rates are available. Thus, the IRA owner may be able to better plan by choosing to recognize the income in the year that results in the lowest income tax liability.

Those taxpayers who can afford to bear the entire tax burden in 2010 may elect to do so to capitalize on historically low income tax rates, which are anticipated to rise after 2010. The upcoming tax year also presents the opportunity to convert at a time when asset values are still well below the highs reached prior to the recent decline in the stock market. Converting these lower asset values would result in paying less tax than converting after a full market recovery.

Before deciding on a Roth IRA conversion, taxpayers should consider several critical factors, beyond their age, assets, and current and future income, including:

  • Whether you anticipate being in the same, or a higher, tax bracket in the future;
  • Whether you currently have the means to pay the tax resulting from a conversion;
  • Whether you have any deductions, carry-forwards, or net operating losses that can be used to offset any tax liability incurred as a result of a conversion;
  • Whether you intend to use your Roth IRA to fund retirement, or to preserve wealth for your heirs; and
  • Whether you are likely to be subject to an estate tax.

One final consideration is that even if you elect to convert to a Roth IRA, you may undo a conversion, for any reason, before the due date of your income tax return for the year of conversion. For example, if you own a traditional IRA and convert to a Roth IRA in 2010, you have until April 15, 2011, or October 15, 2011 if you file an extension, to undo the conversion without reporting any income. A taxpayer might consider this if the value of the assets drops after conversion. You may still decide to convert in a subsequent tax year. Of course, in such case, you would forego the 2010 opportunity to spread the tax burden over two years.

Ultimately, the only way to determine whether you will benefit from a Roth IRA conversion is to engage in an in-depth analysis of your current and projected financial situation and goals. If you are in a position to take advantage of this unique opportunity, you should be prepared to reassess and possibly recalibrate your investment and estate plans in 2010, for retirement and beyond.