The Roth conversion decision is based upon many moving parts
Taxpayers can convert their Indiviual Retirement Account (IRA) to a Roth regardless of theit income level. Unfortunately, the decision is anything but crystal clear. This discussion will be undertaken in a question and answer format. Note: this discussion was based upon converting to a Roth IRA in 2010. While the conversion in 2011 results in taxable income all in 2011, the remaining principles still apply.
What is a Roth IRA ?
*Contributions are not tax deductible and qualified withdrawals are not taxable. Earnings in a Roth IRA like a traditional IRA grow tax deferred (tax-exempt).
*There are no lifetime required minimum distributions from a Roth. A Roth IRA can be passed on to a beneficiary who can take tax free withdrawals. A non-spouse beneficiary must take minimum distributions starting at age 701/2, but they are withdrawn tax free.
*Note that a withdrawal from a Roth cannot satisfy a taxpayer's minimum distribution requirement from other taxable retirement accounts.
*Contributions to a Roth IRA have special rules-the amount allowed is phased out for single taxpayers with adjusted gross income above $95,000 and $150,000 for married filing jointly.This restriction is not changing. There is no such rule for a traditional IRA although a part or all of the IRA may not be tax deductible. Remember all Roth IRA contributions are made with after-tax funds.
*Taxpayers not eligible to contribute to a Roth IRA could contribute to a nondeductible IRA and then convert it to a Roth IRA without any tax consequence.
*Contributions to a Roth may be made after age 701/2 if taxpayer has earned income.
*Prior to 2010 if a taxpayer's modified adjusted gross income exceeded $100,000, they could not do a conversion-convert a traditional IRA to a Roth IRA. If they could convert, the amount is added to the taxpayer's income for that year.
*Effective with 2010 conversions, there are no restrictions (income levels) for a taxpayer to convert a traditional IRA to a Roth IRA. For 2010 conversions, the federal income tax to be paid on the conversion is deferred to 2011 and 2012. For example, a conversion of $50,000 in 2010: $25,000 taxed in 2011 and $25,000 taxed in 2012. Taxpayer can elect to pay tax in 2010. After 2010 the full amount of conversion is taxable in the year of conversion.
Have to consider tax rates after 2010 especially with the Bush tax cuts expiring.
*In addition to traditional IRAs, starting in 2008, 401(k) plans, profit sharing plans, 403(b) plans and 457 plans can be converted to a Roth IRA. "Inherited IRAs and Education IRAs CANNOT be converted to a Roth IRA.
*Married filing separately taxpayers can convert to a Roth IRA.
Why convert to a Roth IRA if I have to pay income taxes?
This is where it can get interesting........
*Roth IRA grows tax free but you must consider current and future tax rates in your analysis. Generally it will be beneficial if the taxpayer's income tax bracket will be the same or higher in retirement. You also should have funds available in a taxable account to pay for the conversion. It does not make much sense to take additional funds out of a tax deferred account to pay income taxes and a possible 10% penalty for a premature distribution for funds not being converted to a Roth............ * Also, the longer you are away from retirement, the more a conversion may make sense. Should do the analysis which does require assumptions, such as future investment growth rates and income tax rates. Will the long-term benefits of the tax free accumulation inside a Roth justify paying taxes before you are required to pay if left in a traditional IRA?
*You should also estimate what your income in retirement could be. This is easier for a 55 year old than say a 40 year old.
Who knows what tax rates will be in 25 years (or what the tax structure will then be) yet try and forecast what they will be in 5 years. Remember our current tax tables are indexed for inflation. There is the possibility you may not be in a higher tax bracket, or you could be in the same or lower tax bracket depending on your retirement income, tax law changes and the indexing of tax brackets for inflation.
*Taxpayers can keep their investment in a Roth for a longer period of time and not have to take minimum distributions as previously discussed.
*For larger estates subject to Federal estate taxes, paying the income tax on conversion will pass the Roth and income from
the growth tax-free to the beneficiaries (an income-tax-free inheritance to heirs). However, some may argue why pay the tax bill now when there may be other estate tax planning techniques which should be explored.
*Remember with a traditional IRA in an estate, the estate tax is paid first, then the income tax. With a Roth IRA in an estate, the income tax has already been paid, so the estate tax, if any is only on the amount in the Roth.
*If a taxpayer has favorable tax attributes in a particular year such as large charitable deductions, net operating loss and investment tax credits, a conversion may be beneficial. Do the tax planning analysis.
*Because federal tax brackets are more favorable for married couples filing joint returns than for single individuals, Roth IRA distributions will not cause an increase in tax rates for the surviving spouse when one spouse is deceased because the distributions are tax-free. But again, assumptions are being made today for the future which is by no means certain.
*PLANNING POINT-No one of course knows what the future will bring and if assumptions used today will be viable in the future. There is nothing that says one has to convert all their traditional IRAs to a Roth IRA. You may want to consider to just convert part of your retirement funds to a Roth. This will enable you to have two "buckets" for retirement that you can use to help plan your particular tax situation in retirement.
*POINT TO CONSIDER-Some may say why now pay the tax bill when I have saved on my tax bill over the years by having a retirement plan. The government wins now by getting my tax dollars and I have no control over the future and what the tax rates could be in the future. Also, I will be paying state income taxes today on the conversion and what if I retire to a state that has no income tax or favors the taxability (not taxing) of retirement income? Is this worth it?
*ANOTHER POINT-Know what fees you will incur if someone offers you a new investment in a Roth. Changing investments from one mutual fund or broker to another fund or new brokerage/investment house could be costly. Ask the person who suggest such a move what the costs(i.e. commissions) are.
Is there a Tax Impact of converting to a Roth IRA on taxpayer's adjusted gross income?
Remember, the conversion amount is added to taxpayer's income.........
*Social Security payments-more could be added to taxable income.
*Higher income could result in higher monthly premiums for Medicare Part B.
*Need to review the deductibility of traditional IRA contributions.
*Possible phase outs of personal exemptions and itemized deductions.
*Loss of education credits.
*Will there be an impact on FSFSA application statements for college?
Again, see what the tax implications are based upon your situation.
Are there special rules, taxes, etc. on taking distributions from a Roth IRA?
Any distribution within the first 5 taxable years in the Roth is NOT a qualified distribution.........
*For withdrawals to be penalty free there is a 5 year rule which for the most part works the same for people who open a Roth IRA and for those who convert a traditional IRA to a Roth IRA.
*An owner of a Roth can withdraw the original contribution ANYTIME with no tax penalty. Remember there is no regular income tax since the tax has already been paid.
*The 5 year "clock" starts January 1 of the year the first ROTH contribution was made. The "clock" does not reset each time a contribution is made or another Roth account is open. The 5-year period continues to run when the participant dies.
*For conversion contributions you have to hold amounts in the Roth for 5 years or until age 591/2, whichever comes first, to avoid the 10% penalty for early withdrawals of converted amounts. Each conversion has its own 5 year "clock".
*If already 591/2 and convert a traditional IRA to a Roth, you can withdraw from your Roth at anytime without the 5 year deadline or penalties.
*Need to understand the taxation of any earnings on converted amounts. You have to hold a Roth IRA 5 years to withdraw any earnings tax free. The withdrawals however are on a first-in-first out basis; distributions first come from contributions, then conversions, then earnings.
*Example-1) Brett age 62 contributed $1000 into a Roth IRA 10 years ago when he was 52. Brett meets the age and 5 year holding period. Brett's withdrawals are all tax free-no penalty or income tax.
*Example-2) Assume Brett now converts $100,000 from a traditional IRA to a Roth. Brett pays the income tax and he could withdraw the $100,000 with no penalty or tax-The 5 year period started the first day Brett opened the Roth IRA ten years ago.
*Example-3) Assume Alexis is age 40 and opened a Roth IRA 10 years ago with $1,000. Ten years later Alexis converts $100,000 to a Roth IRA. If Alexis withdraws The $100,000 a year later at age 41, she will owe a 10% penalty on all converted amounts. Even though the Roth IRA has been open 5 years-each conversion starts a 5 year clock until you turn 591/2.
*Example-4) Jeff has a traditional IRA with a value of $30,000, consisting of deductible contributions and earnings. He converts the IRA to a Roth IRA in 2010 and elects not to recognize income in 2010. If Jeff takes a $5,000 distribution from the Roth IRA after conversion, he must include the $5,000 in income for 2010, $15,000 in 2011 (the lesser of half the income from conversion or the remaining untaxed income from the conversion) and the remainder of $10,000 in 2012.
After I convert my traditional IRA to a Roth, can I later convert back to the traditional IRA?
This is called a Recharacterization.............Usually done if portfolio has declined after conversion.......
*Taxpayer can elect to undo or "recharacterize" the conversion of a traditional IRA to a Roth IRA. If taxpayer elects to convert in January 2010 and the value of the Roth investments drop any time before October 15, 2011, taxpayer can put the assets back into a traditional IRA (undo the tax bill) and then elect a Roth conversion at a new lower asset value within stipulations provided.
*The recharacterization can undo an invalid contribution (income levels) or conversion, or even if taxpayer just changes their mind about the Roth conversion. The deadline is October 15th of the following year; the extended due date of personal returns.
*However, taxpayer cannot convert (re-convert) the same funds back to Roth until the LATER of the year AFTER recharacterization conversion OR 31st day after recharacterization.
*Example A -Converted February 2010-Recharacterized December 9, 2010-Reconvert the later of January 1, 2011 (year after) or, January 8, 2011 (31st day after recharacterization transfer).
*Example B-Converted February 2010-Recharacterized January 5, 2011-Reconvert the later of January 1, 2011(already passed) or, February 5, 2011 (31st day after recharacterization transfer).
*Taxpayers cannot recharacterize a portion of a Roth conversion by "cherry picking" only those stocks or funds that may decline in value. Consider setting up multiple ROTH IRA accounts if you are converting a large amount of money. Then keep the good ones and recharacterize the losers. Taxpayer could set up a Roth IRA for each asset class i.e. large cap, international, small cap, sector, bond fund, etc. (separate conversions). This will allow the owner to pick and choose recharacterizations. Then after the recharacterization deadline merge all accounts.
*Planning point-To be sure, for the tax return due for the year of conversion, consider filing an extension (extends return to 10/15). You could then still file by the due date (4/15), but you know for sure your return is extended in case you recharacterize.
Is there anything else I should know?
*Unless you convert 100% of all IRA accounts, only a portion of the nondeductible IRA accounts can be converted. Cannot just transfer nondeductible contributions.
*IRA is a non-probate asset. The IRA designated beneficiary form will govern who receives IRA funds at owners death.
*Re: First time Homebuyer-With a traditional IRA, owner can withdraw $10,000 penalty free for purchase. With a ROTH, owner can withdraw $10,000 of earnings penalty free and income tax free for first time homebuyer once account is more than five years old.
*Besides future tax rates and tax structure to be considered (consumption tax with income tax?), do we need to factor in that in 15-25 years there will be different lawmakers in Washington? Will they look at the ROTH as a source of income tax? Or, will they just tax large balance ROTH accounts with some type of surtax? Who thought social security would be taxable? A Roth IRA is not taxable as long as Congress says it is not taxable.
The ROTH conversion-it is your decision!