2010 Presents a Potential Planning Opportunity Through Roth IRA Conversions
Beginning in 2010, a planning opportunity becomes available for all individuals owning traditional IRAs. The Tax Increase Prevention and Reconciliation Act of 2005, which was signed into law on May 17, 2006, eliminates the income limitation applicable to converting a traditional IRA into a Roth IRA. Roth IRAs have been around for more than a decade, but due to various income limitations, they have not been available to the affluent. By eliminating the income limitation applicable to conversions of a traditional IRA into a Roth IRA, the Roth IRA will become more widely available.
In 2009 and prior years, an individual with adjusted gross income (with certain modifications) of $100,000 or less could convert a traditional IRA into a Roth IRA. As to contributions to a Roth IRA, the income limitations are a little more generous. In 2009, the following rules apply:
- a married individual, who files jointly, may not contribute to a Roth IRA if his or her adjusted gross income (with certain modifications) exceeds $176,000, and may only contribute the maximum amount if his or her adjusted gross income is $166,000 or less
- an unmarried individual may not contribute to a Roth IRA if his or her adjusted gross income (with certain modifications) exceeds $120,000, and may only contribute the maximum amount if his or her adjusted gross income is $105,000 or less
- the maximum contribution to a Roth IRA is $5,000 (or $6,000 for individuals age 50 and over.
By eliminating the income limitation on converting traditional IRAs into Roth IRAs, Congress has effectively allowed individuals to circumvent the income limitations applicable to making contributions to a Roth IRA. In other words, an individual could simply make a contribution to a traditional IRA and then convert it into a Roth IRA, regardless of income. It is unknown if Congress will seek to address this loophole.
Benefits of a Roth IRA
A Roth IRA can provide numerous planning benefits. In general, assets contained in a Roth IRA and distributions from a Roth IRA are not subject to income tax. Also, there are no required minimum distributions when an individual reaches age 70-1/2, as is the case with other retirement accounts, such as traditional IRAs. These two features of a Roth IRA allow an individual to create a pool of assets that will never be subject to income tax, and that could potentially continue for decades depending upon the designated beneficiaries named under the Roth IRA.
If the husband owns a Roth IRA, then he would not be required to take distributions from it during his lifetime. If the husband named his wife as sole beneficiary of that Roth IRA, then at the husband’s death, the wife could roll it over to create her own Roth IRA and she would not be required to take distributions from it during her lifetime. The wife could name a grandchild as the designated beneficiary of the Roth IRA, which means the grandchild must begin taking required distributions after the death of the wife. Depending upon the ages of the husband and wife, the Roth IRA assets could grow untouched for decades, and when the grandchild is required to take distributions after the death of the wife, those distributions could be spread over the grandchild’s life expectancy.
It may be helpful to apply some real numbers to this example to fully appreciate the planning opportunity. Assume that the husband is 50 years old when he converts a $100,000 traditional IRA into a Roth IRA. If the securities held in that Roth IRA appreciate at a 7.5% annual rate, and the husband dies at age 70, then the Roth IRA would have a balance of approximately $425,000 at that point, assuming the husband does not take any distributions from it during his lifetime. If the wife then rolls it over to create her own Roth IRA, and she lives another 10 years without taking distributions from it, then the balance would be approximately $875,000 at her death. If a 40-year-old grandchild is named as the sole beneficiary of the Roth IRA, then he or she would be able to take distributions over his or her life expectancy, which is nearly 44 years under the applicable tables. If the grandchild took the minimum required distributions over the next 10 years, then the balance would grow to more than $1.4 million, and the grandchild would have received tax-free distributions totaling more than $280,000 over those 10 years. Keep in mind that these results stem from a $100,000 Roth IRA established 40 years earlier, and the grandchild still has many more years of tax-free compounding.
The price that must be paid for this tax-free growth is current income taxation on the taxable portion of the traditional IRA in the year of conversion into a Roth IRA. A traditional IRA may consist of deductible and/or nondeductible contributions, depending upon whether the contributor (or his or her spouse) was an active participant in an employer-sponsored retirement plan, and depending upon his or her adjusted gross income. To the extent a traditional IRA was funded with nondeductible contributions, there would be no taxation upon the conversion into a Roth IRA. To the extent a traditional IRA was funded with deductible contributions (and to the extent of the growth on all contributions), there would be taxation upon the conversion into a Roth IRA.
Assume that an individual had a traditional IRA valued at $50,000 that was funded solely with deductible contributions, and he or she also had a traditional IRA valued at $20,000 that was funded with $12,000 of nondeductible contributions. If that individual converted both traditional IRAs into Roth IRAs, then he or she would have $58,000 ($70,000 minus $12,000) of ordinary income subject to tax. It should be noted that this individual could not simply convert the traditional IRA that contains nondeductible contributions into a Roth IRA in order to minimize his or her income tax liability. In other words, “cherry picking” is not allowed, and all traditional IRAs must be aggregated for purposes of determining the taxability of a conversion. The individual could, however, minimize his or her income tax liability by converting one-half of his or her traditional IRAs, which would result in $29,000 ($35,000 minus $6,000) of ordinary income subject to tax.
Conversion Is Not for Everyone
Conversion of a traditional IRA into a Roth IRA is not for everyone. Many individuals may prefer to defer income taxes, rather than trigger current income tax liability with a conversion. A conversion is most advantageous under one or more of the following circumstances: (1) an individual expects to be in a higher income tax bracket during retirement when he or she plans to take distributions from the Roth IRA; (2) an individual has a traditional IRA that was funded with a significant amount of nondeductible contributions, so the income tax impact of a conversion is minimized; (3) an individual will not need the Roth IRA assets to fund retirement, but would prefer to use it as a vehicle to benefit heirs; and (4) an individual has sufficient assets outside of his or her traditional IRA with which to pay the income tax triggered by the conversion.
Reasons to Convert
Under the Tax Increase Prevention Act of 2007, Congress provided an extra incentive for individuals to convert their traditional IRAs into Roth IRAs in 2010 by allowing the amount of income from a 2010 conversion to be spread ratably over 2011 and 2012. This tax deferral is available for 2010 conversions only. Clearly, Congress views conversions into Roth IRAs as a revenue raiser, and wants to encourage taxpayers to join in.
From an estate planning perspective, it is important to keep in mind that taxable retirement accounts (like traditional IRAs) are not the best assets to leave to heirs, because they are potentially subject to both the estate tax and the income tax when distributions are made to heirs. The income tax hit to heirs may be alleviated somewhat by a deduction under Section 691(c) of the Internal Revenue Code, but this deduction is not always complete. By leaving a Roth IRA to heirs, however, an individual avoids the potential income tax liability.
In deciding whether or not to convert a traditional IRA into a Roth IRA, it is difficult to predict where income tax rates will be in the future, but many advisors view a Roth IRA as a hedge against a potential spike in income tax rates. Also, many advisors suggest “tax diversification,” which means you own assets that are subject to different forms of taxation. For example, you maintain some tax-free assets (like assets held in a Roth IRA), some assets subject to ordinary income tax rates (like assets held in a 401(k) or traditional IRA), and some assets subject to capital gains rates (like stocks held in a brokerage account). This way, during retirement, you have options depending upon the income tax regime in place.
In conclusion, the conversion of all or part of an individual’s traditional IRA into a Roth IRA is a planning opportunity that should be explored now that the income limitation will be eliminated in 2010 and beyond.