Roth IRAs in brief A Roth IRA is subject to many of the same rules that govern traditional IRAs. For example, the penalty tax for excess contributions, the prohibition against pledging or borrowing from the account, and the rules regarding the types of assets that can be contributed apply to Roth IRAs as they do to traditional IRAs.
However, several unique, generally favorable provisions apply to Roth IRAs. These features include relaxed required minimum distribution rules, the ability to make contributions after age 70 ½ and no taxation of earnings. Traditional IRA holders can often benefit from these features by converting to Roth IRAs.
Conversion from traditional IRAs and qualified plans Converting your traditional IRA to a Roth IRA can allow post-conversion income to grow tax-free in the Roth. For 2009 a conversion (or rollover) is permitted only if your AGI, calculated with specified modifications, does not exceed $100,000 in the rollover year. Any funds rolled over will be taxed under the traditional IRA distribution rules, but the 10 percent early withdrawal penalty will not apply.
For tax years beginning after 2009, the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated. Additionally, the payment of income tax on conversions in 2010 can be deferred until 2011 and 2012. These law changes can result in a significant tax deferral now and significant tax savings in the future.
Qualified plan note: Eligible distributions from 401(k), 403(b) and 457(b) plans may also be rolled directly to a Roth IRA. Rules very similar to those for conversions from traditional IRAs apply.
Impact of future tax rates Conversion to a Roth IRA is beneficial only if the future tax savings (when funds are withdrawn) are greater than the tax paid on conversion. While it’s best to “run the numbers,” some rules of thumb can be used: (1) the longer you plan to wait before withdrawing funds, the more likely the future tax savings will outweigh tax on conversion; (2) if future tax on traditional IRA distributions will be at a lower rate than the tax rate effective on conversion, paying the tax to convert to a Roth may be a mistake.
Absent Congressional action, after 2010 the tax brackets above the 15 percent bracket will revert (increase) to pre-2001 levels. That means the top four brackets will be 39.6, 36, 31 and 28 percent, instead of the current top four brackets of 35, 33, 28 and 25 percent. As of mid-October 2009, the Administration has proposed to increase taxes only for those making $250,000 or more, but it is difficult to predict who will get hit by higher rates. What’s more, there are proposals on the table to help finance healthcare reform with a surtax on higher income taxpayers. A reversion to pre-2001 rates will increase the potential future benefit of a 2009 or 2010 Roth conversion.
Taking action Individuals who intend to take advantage of the new Roth IRA conversion option in 2010 should consider the following income tax planning strategies:
– Taxpayers who are eligible to make deductible IRA contributions in 2009 should do so. They’ll reduce their 2009 tax bill and, if they make the conversion to a Roth IRA next year, they won’t have to pay back the tax savings until 2011 and 2012.
– Taxpayers who were not eligible to make deductible IRA contributions in the past (or made a tax-free rollover from a qualified plan to an IRA) should consider making nondeductible IRA contributions in 2009. The conversion generally is taxable only to the extent of earnings on the nondeductible contributions. However, if the taxpayer previously made deductible IRA contributions, or rolled over qualified plan funds to an IRA, complex rules determine the taxable amount.
– Some taxpayers plan to make large conversions in 2010 but plan to opt out of the deferral of tax until 2011 and 2012 because they fear they will be in a higher tax bracket in those years than in 2010. These taxpayers should avoid the standard year-end planning wisdom of accelerating deductions and deferring income but should, rather, do the reverse in an effort to avoid being pushed into the highest tax brackets by a large Roth IRA conversion. These taxpayers should be considering ways to defer deductions to 2010, and accelerate income from next year into 2009.
– Taxpayers who have never opened a traditional IRA because they weren’t able to make deductible contributions should consider opening such an IRA in 2009 and making the largest allowable nondeductible contribution they can afford; e.g., even by taking funds out of savings. If they convert the traditional IRA to a Roth IRA next year, they will have to include in gross income only that part of the amount converted that is attributable to income earned after the IRA was opened, presumably a small amount. In 2010 and later years, they could continue to make nondeductible contributions to a traditional IRA and then roll the contributed amount over into a Roth IRA.
IRAs continue to be a valuable tax deferral and retirement planning tool, but the complexity of IRA rules, the multiple IRA options available, and the numerous other qualified plan choices can be daunting. With expert advice and planning, you can make the rules and options work to your benefit. Speak with your CPA or other qualified tax adviser to decide how a Roth IRA may benefit your existing income tax and retirement planning.
This article provides general information and may not apply to your particular situation. In addition, this article does not offer legal or tax advice.
The Internal Revenue Service recently issued regulations that require written advice regarding tax matters to meet very detailed and comprehensive requirements before it can be relied upon by a taxpayer to avoid penalties that might apply if the tax benefits or results discussed in this article are disallowed. Compliance with these rigorous standards and requirements exceeds the scope of this article. Consequently, the analysis and advice contained in this article regarding federal tax matters is not intended to be used, and may not be relied upon by you or anyone else, for the purpose of avoiding any federal tax penalty.
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D. Craig Godfrey, firm managing partner of Godfrey Wise Berg CPAs and advisers, LLC (GWB), has over 20 years of experience in taxation. Godfrey has a diverse client base and provides a wide range of services specializing in the areas of individual and business taxation. Martin T. Comden, CPA, MBA, is also with the firm of Godfrey Wise Berg, CPAs & advisers, LLC as a senior tax manager. Comden has more than 15 years of experience as a certified public accountant. His area of expertise is federal and state income tax planning and tax compliance for small and mid sized owner-managed companies and individuals.