Converting traditional IRAs and qualified retirement plan accounts to Roth IRAs is a hot topic today. The reason: The Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) repealed the income limits on eligibility to make a conversion after 2009; anyone is eligible to make a conversion in 2010 and later years. Here are some key points to take into account when deciding whether to make a conversion this year and how much to convert.
Basic Rules
Starting this year, anyone, regardless of income or filing status, can opt to convert a traditional IRA or qualified retirement benefits to a Roth IRA (Code Sec. 408A(c)(3)(B) repealed). The advantage for making a conversion is the opportunity to build tax-free income for the future. Moreover, because there are no required minimum distributions from a Roth IRA during the owner's lifetime, there is also the prospect of creating a sizable legacy if the funds are not needed during retirement. The main disadvantage to making a conversion is paying income taxes on the amount converted rather than deferring taxes until such amounts are withdrawn.
Conversions in 2010 allow the taxpayer to spread the resulting income over two years—2011 and 2012. This effectively defers the tax on the conversion for some time (Code Sec. 408A(c)(3)(B)). Alternatively, a taxpayer can elect to report all of the income from the conversion in 2010 (Code Sec. 408A(e)(i)(I)). (The cases for doing this are discussed below.)
Income from conversions made after 2010 must be reported in full in the year in which the conversions are made; there is no deferral rule for conversions after 2010.
Conversion income. If the converted account has only pre-tax contributions, then it is fully includible in gross income. So, if the IRA has been funded by tax-deductible contributions, any conversion of the funds in the IRA results in full inclusion in income. If the account has been funded with both deductible and nondeductible contributions, then only a portion of the converted amount is included gross income.
For example, if a person has a single traditional IRA of $25,000 to which he/she had made a nondeductible contribution of $4,000, then 84% of the conversion, or $21,000, is taxable, while 16% represents the after-tax contributions to the traditional IRA and is not taxed. The value of amounts in all nondeductible IRAs is taken into account in determining the tax on the conversion, even if some or all of the nondeductible IRAs is not converted.
There is no 10% penalty on conversion income even though the individual is under age 59 ½, as long as the funds remain in the Roth IRA for at least five years. The fact that the traditional IRA being converted was a rollover made within 12 months does not bar the conversion of this account to a Roth IRA.
Impact of Conversion
Making a conversion can impact other tax rules. Income from the conversion is part of adjusted gross income, an amount that limits or bars eligibility for various tax deductions and credits as well as other rules.
Those at or near retirement age should consider the timing and amount of a conversion carefully. The conversion can:
- Impact the amount of Social Security benefits being taxed. The conversion amount can, for example, raise the amount of benefits included in income from zero to 50% or 85%.
- Affect whether the Medicare surtax applies. Income from the 2010 conversion reported on a 2010 return could trigger or increase Medicare surtax for 2012.
State income taxes. A handful of states have no income tax, so there is no impact from a conversion on state income taxes for individuals in these states. Some states may exempt some or all of IRA distributions from their income tax, which would also mean little or no tax from the conversion. In other cases, a conversion can result not only in federal income taxes, but state income taxes as well.
Annual contributions. An individual can make a conversion and an annual contribution to a Roth IRA. For 2010, the contribution limit remains $5,000, plus an additional $1,000 for those 50 years or older by the end of the year (Code Sec. 408A(c)(2)).
However, there continues to be modified adjusted gross income (MAGI) limits on eligibility to make annual contributions to a Roth IRA. A full contribution is allowed for 2010 for singles with MAGI up to $105,000 and for joint filers with MAGI up to $167,000. A partial contribution is allowed for singles with MAGI between $105,000 and $120,000, and for joint filers with MAGI between $167,000 and $177,000.
Estimated taxes. If conversions are made in 2010 and the income will be reported in full on the 2010 return, then estimated taxes for the year should be made to cover the tax liability and avoid estimated tax penalties. Alternatively, estimated taxes for 2011 and 2012 will have to be adjusted for conversion income.
Planning Strategies
Electing not to use the 2011/2012 deferral option. It is too early to decide whether to opt to report all of the resulting income from a conversion in 2010 on a 2010 return rather than reporting half in 2011 and 2012. It depends in part of what the tax rates will be for the client in 2011 and 2012.
The president's budget proposal for fiscal year 2011 calls for a hike in the top tax rates for so-called high income taxpayers to 36% and 39.6%, up from 33% and 35%. The tax bill on the conversion could be lower for high income taxpayers if the full amount is included in income in 2010 and subject to a lower rate. Alternatively, individuals converting may now be retired and in lower tax brackets in 2011 and 2012, even if tax rates rise.
If an individual converts more than one account to a Roth IRA in 2010, the same tax treatment — full income in 2010 or deferral to 2011 and 2012 — must be used for all of the accounts. If the individual is married, each spouse can choose the tax treatment for his/her separate IRAs, so one spouse can report conversion in 2010, while the other spouse can defer the income from the conversion to 2011 and 2012.
Match cash to conversion amounts. In order to make a conversion, it is important to have sufficient cash on hand to pay the tax that results from the conversion. It is advisable to convert only as much as the cash available to pay the taxes.
Partial conversions. There is no rule requiring an individual to convert all of his or her IRAs. A portion of an account can be converted in 2010, with additional conversions made in future years.
Separate accounts. Conversions can be "undone" by recharacterizing the converted amount no later than October 15th of the year following the year of conversion (e.g., October 15, 2011, for 2010 conversions). Recharacterization removes the converted amount from income and may be advisable when the value of the account drops considerably from the time of the conversion. However, recharacterization must be made for the entire Roth IRA account; no partial recharacterizations are permitted.
It may be advisable to set up separate Roth IRAs to hold conversion amounts that are invested in different classes of assets. Then, if a particular asset class has disappointing results following a conversion, a recharacterization can be made of the separate account.
Direct conversions. Individuals can convert a 401(k) or other qualified retirement plan directly into a Roth IRA and do not have to first transfer funds into a traditional IRA and then convert. However, the ability to make a conversion from a qualified retirement plan depends on the terms of the plan. Usually the option to convert is available only when an employee leaves the company or retires, so check with the plan administrator for details.
Required minimum distributions. No conversion is allowed for the portion of the account required to be distributed for the year as a required minimum distribution (RMD); only amounts in the account after RMDs can be converted. For example, say there is a traditional IRA with $50,000 and the RMD for 2010 is $2,000. The maximum amount that can be converted in 2010 is $48,000.
Final decision. Whether to convert is a complicated decision based on an individual's current tax picture and future estimates. It may be helpful to use a calculator, such as one from CalcXML at www.calcxml.com/do/qua04, or for professionals, from CCH at http://tax.cchgroup.com/roth-ira-conversion-expert/default.htm. The following tools also will help make a determination:
- Fidelity: https://calcsuite.fidelity.com/rothconveval/app/launchPage.htm.
- Schwab: www.schwab.com/public/schwab/planning/retirement/iras/roth_ira/roth_ira_conversion/considerations/roth_conversion_calculator.
- Vanguard: www.archimedes.com/vanguard/roth/RothConsumer.phtml.
Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.
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