January 1, 2010 wasn’t just the first day of the new year and the start of a new decade. It also launched a new era for the Roth IRA. Now, anyone can convert a traditional IRA to a Roth to take advantage of its tax-free compounding and income. And if you act this year, you can spread out—and possibly reduce—your income tax bill on the conversion.
Traditional IRAs are generally built with tax-deductible contributions, but withdrawals during retirement are taxed. With a Roth IRA, it’s just the opposite—contributions aren’t deductible, but “qualified distributions” from an account you’ve had at least five years are completely tax-free once you reach age 59½. And because your withdrawals aren’t taxed, the government doesn’t require you to take any during your lifetime. That’s in contrast to a traditional IRA, which normally mandates minimum annual distributions after age 70½.
Although to convert a traditional IRA to a Roth you still must pay income tax on the account’s taxable portion—the part representing tax-deductible contributions and earnings—this can be a pretty good deal for many people. But until 2010, the opportunity was off-limits to many, because you could do a Roth conversion only in a year in which your modified adjusted gross income didn’t exceed $100,000. That cap disappeared on January 1. And if you convert this year, you can spread out the income and resulting tax liability over the next two years—2011 and 2012. Being able to pay in installments could save you thousands of tax dollars if it prevents you from rising into a higher tax bracket.
Suppose, for example, you decide to convert your traditional IRA valued at $200,000 into a Roth IRA. The full amount being converted is subject to tax. For simplicity, let’s say that the first $75,000 is taxed in your current 28% tax bracket and the remaining $125,000 is taxed at the 33% rate. Normally, that would add up to income tax of $62,250 on the conversion (28% of $75,000 + 33% of $125,000).
However, if you convert that $200,000 traditional IRA to a Roth in 2010, you can spread out the income so that $75,000 is taxed at the 28% rate in each of the following two years and only $25,000 is taxed at the higher rate each year. (This assumes that your taxable income and the tax rates remain the same after 2010.) Besides postponing part of your payment, splitting your income in two reduces your overall payment. By paying the tax on $100,000 of the conversion each year, you cut your tax bill to $29,250 each year—28% of $75,000 + 33% of $25,000. That’s a total of $58,500—or $3,750 less than if you paid the full tax in the first year.
But if tax rates rise in 2011, the math on Roth conversions might not be so favorable. And unless Congress acts, that’s what will happen. Today’s tax rates were established by a 2001 law whose provisions expire at the end of 2010, when tax brackets are set to be adjusted upward. The top income bracket, for example, is scheduled to rise from 35% to 39.6%. But if that happens, and delaying part of your liability would mean paying a higher rate, you could simply choose to report all of the income on the return you file in 2011 for the 2010 tax year. Keep in mind, though, that it’s generally advantageous to use non-IRA funds to pay conversion taxes, and spreading out the tax—even if it meant paying part of it at a higher rate—might make it easier for you to come up with the money without tapping your retirement funds. A Roth IRA conversion usually makes sense if you expect to be in your current tax bracket (or a higher one) when you tap the Roth during retirement, you won’t need to take distributions for at least five years, and, again, you have enough cash on hand to pay tax on the conversion without eroding your IRA nest egg. And if you won’t need the IRA during your lifetime, converting it to a Roth will increase its value for your beneficiaries. You won’t have to take taxable distributions, as you would with a traditional IRA, and your heirs won’t be taxed on their withdrawals—though, unlike you, they’ll be required to take minimum distributions.
But a Roth conversion isn’t right for everyone, and in some cases it works best to convert only part of a traditional retirement account. You might, for example, choose to convert only the portion of your IRA that you expect to be able to leave to your heirs. Weighing all of the relevant factors can be difficult, and most online calculators leave out important considerations. If you would like help deciding whether a Roth IRA would be beneficial in your financial situation, please call our office to make an appointment.