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ROTH IRA CONVERSIONS IN 2010:
How To Utilize Roth IRAs In Your Personal Income Tax Plan
By Matthew S. Beard and Tyler S. Andersen
Summary
Beginning in 2010, all persons may take advantage of a previously restricted income tax
planning tool: the taxable conversion of a traditional IRA (or qualified plan) to a Roth IRA.
This tool is commonly known as a “Roth Conversion.”
Additionally, taxpayers with income under the applicable phase-out limitations may
make contributions directly to a Roth IRA.
The following is a summary of how to utilize the opportunities presented by Roth IRAs
in your personal income tax plan.
Background
IRAs are vehicles designed by Congress to encourage saving through significant tax
incentives. Two common types of IRAs are: (1) traditional IRAs; and (2) Roth IRAs.
Both types of IRAs permit the funds inside the IRA to grow free of income tax. However,
the IRAs differ as to how contributions and
Comparison of Tax Benefits
distributions are taxed.
In most cases, contributions to a traditional
IRA are deductible, subject to phase-out limitations
depending upon your adjusted gross income
(“AGI”).
A tax is generally imposed on
distributions from a traditional IRA; however, the
portion relating to nondeductible contributions to
the IRA are not taxed.
Traditional
IRA
Roth IRA
Contributions
Generally tax
deductible;
deductions
subject to
phaseouts
Never deductible;
contributions
subject to
phaseouts
Growth
Tax deferred
Tax free growth
Taxation of a Roth IRA is essentially the
growth
mirror image of taxation of a traditional IRA.
Contributions to a Roth IRA are never deductible,
Distributions Generally
Distributions of
taxed; portion contributions not
regardless of your income level. A tax is not
attributable to taxed;
imposed on distributions from a Roth IRA if the
nondeductible distributions of
distribution is a qualified distribution or a return
contributions
earnings not taxed
of your contributions. A “qualified distribution”
not taxed
if qualified
must meet two tests: (1) the distribution must be
distributions
made after the five-year period beginning with the
first taxable year for which a contribution was made to a Roth IRA established for your benefit;
and (2) the distribution is made (a) on or after the date you reach age 59½; (b) because you are
disabled; (c) to a beneficiary or to your estate after your death; or (d) pursuant to the
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requirements for a first time home buyer. In essence, the Roth IRA permits tax free growth,
whereas the traditional IRA permits tax deferred growth.
Although the taxation of IRAs is complex, the decisions you face with respect to your
personal income tax plan can be simplified to the following: (1) Should you make contributions
directly to a Roth IRA?; and (2) Should you convert your traditional IRA (or qualified plan) to a
Roth IRA?
Taxpayers With Income Under Phase-outs: Consider Contributions
If your filing status is single and your modified AGI is under $120,000, then you may
make contributions to a Roth IRA. However, your ability to make contributions to a Roth IRA
begins to phase-out if your modified AGI is $105,000, and is completely phased-out if your
modified AGI is $120,000 or more. Your total contributions for 2010 to all IRAs, whether Roth
IRAs or traditional IRAs, must total $5,000 or less.
If your filing status is married filing jointly and your modified AGI is under $177,000,
then you and your spouse may each make contributions to a Roth IRA. However, your ability to
make contributions to a Roth IRA begins to phase-out if your modified AGI is $167,000, and is
completely phased-out if your modified AGI is $177,000 or more. Your total contributions for
2010 to all IRAs, whether Roth IRAs or traditional IRAs, must total $5,000 or less per person
(effectively $10,000 or less as a couple).
You should strongly consider making contributions to a Roth IRA if your modified AGI
is under the applicable phase-out limitations. It is not too late to make contributions to an IRA
for the 2009 tax year. Contributions made in 2010 and designated for 2009 should be treated as
being made in 2009 so long as you make such contributions by April 15, 2010.
All Taxpayers: Consider Conversion
Regardless of whether your income is under the phase-out limitations for contributions
directly to a Roth IRA, you should consider a Roth Conversion. Prior to 2010, only certain
taxpayers with modified AGI of $100,000 or less could convert a traditional IRA to a Roth IRA.
Beginning in 2010, no AGI limit exists for Roth Conversions. Thus, persons with higher
income are now permitted to utilize Roth Conversions where they were previously prohibited.
Roth IRAs provide many benefits. The most significant benefit of a Roth IRA is that
both growth and distributions are generally income tax free. Compared to a traditional IRA
where distributions are generally taxed, the Roth IRA essentially permits tax free growth rather
than tax deferred growth. Additionally, Roth IRAs are significant estate planning tools for high
net worth individuals because minimum distributions are not required at any age, compared to
traditional IRAs where minimum distributions are required beginning at age 701/2.
A Roth Conversion can take one of four forms: (1) a withdrawal from a traditional IRA and
rollover to a Roth IRA within 60 days of the withdrawal (this is the least desirable method due
to the risk of mistake in the conversion process resulting in a 10% penalty); (2) a direct
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transfer from the trustee of a traditional IRA to the trustee of a Roth IRA; (3) a redesignation of
an account if the traditional and Roth IRAs have the same trustee; or (4) the conversion of a
qualified plan benefit like a 401(k) plan into a Roth IRA.
The amount converted in a Roth Conversion will be subject to income tax. If properly
and timely converted, the 10% penalty that is generally applicable for early withdrawals from
traditional IRAs should not apply. Ratios are used to determine the nontaxable basis in your
IRAs and the amount subject to income tax. Generally, the portion representing nondeductible
contributions to all your IRAs (excluding Roth IRAs) constitutes basis and is not taxable.
This year should be an attractive year for Roth Conversions. The market is relatively low in
2010, which should result in a lower taxable amount upon conversion. For Roth Conversions in
2010, the default rule is that none of the taxable amount is included in your gross income for 2010,
one-half of the taxable amount is included in your gross income for 2011, and the other one-half of
the taxable amount is included in your gross income for 2012. Although the default rule appears to
be a pro-taxpayer rule, you may elect to include the full taxable amount in your gross income in
2010. Such election may be an attractive option, depending upon your circumstances,
because the highest marginal tax rate in 2010 is 35%, while the highest marginal tax rate in 2011 is
currently scheduled to be 39.6%.
Many financial institutions have published analysis of whether the benefits of a Roth
Conversion outweigh the tax cost. Their results vary and depend upon the circumstances.
However, most would agree that the deciding factors are the length of time before your
retirement, your anticipated future tax bracket, and, most importantly, whether you have
sufficient funds available outside your IRAs to pay the income tax cost of conversion. You
should consult your financial advisor to analyze a Roth Conversion under your circumstances,
and the growth potential following a Roth Conversion.
As an example, assume Husband and Wife have a modified AGI of $300,000 for 2010
and their filing status is married filing jointly. Husband has a traditional IRA worth $200,000
that was funded with $100,000 of nondeductible contributions from prior years. Husband and
Wife have no other IRAs. Although the phaseouts prohibit Husband and Wife from making
contributions directly to a Roth IRA, they have the option to convert their traditional IRA to a
Roth IRA. Their traditional IRA has a basis of $100,000 due to nondeductible contributions, and a
potential taxable amount of $100,000. If they convert in 2010 and elect to include all income in
2010, then their additional tax liability will be approximately $35,000 ($100,000 * 35% =
$35,000). Thus, for a tax cost of approximately $35,000, Husband and Wife can acquire the
benefit of tax free growth of $200,000 in a Roth IRA through a Roth Conversion.
Recharacterization and Reconversion: An Opportunity To Change Your Mind
Two mechanisms are available that permit you to change your mind after a Roth
Conversion: (1) recharacterization; and (2) reconversion. These mechanisms provide you
flexibility to respond to changing or unforeseen circumstances, such as declining market
conditions.
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To recharacterize or cancel a Roth Conversion, you generally must have the assets of the
converted Roth IRA transferred back to the traditional IRA in a trustee-to-trustee transfer by the
due date (including extensions) for your tax return for the year of the Roth Conversion. In the
example above, assume Husband and Wife convert to a Roth IRA in 2010. In March 2011, as
they are preparing their 2010 income tax return, they realize they do not have sufficient assets
outside their IRA to pay the additional $35,000 tax liability arising from the conversion. In such a
case, Husband and Wife should have the assets transferred from the trustee of the converted
Roth IRA back to the trustee of the traditional IRA by April 15, 2011 (assuming Husband and
Wife have not received an extension to file), which should cancel the conversion and the
corresponding $35,000 tax liability.
Following a recharacterization, you may not reconvert to a Roth IRA until the later of the
tax year following the year of the first conversion, or 30 days after recharacterization. This
timing rule is designed to reduce (but not eliminate) your ability to take advantage of market
fluctuations. In the example, assume Husband and Wife convert to a Roth IRA in 2010 when
they believe the market is relatively low. Subsequent to the conversion, the market becomes
even lower. Responding to the decrease, Husband and Wife properly recharacterize their
election in December, 2010. Under the timing rules, the soonest Husband and Wife may
reconvert to a Roth IRA is January, 2011. Thus, Husband and Wife have an option to try the
conversion in 2011 at a lower tax cost (depending upon how the expected higher tax rate of
39.6% in 2011 impacts their analysis).
If you die after making a Roth Conversion, the executor of your estate is permitted to
recharacterize the Roth Conversion before the due date (including extensions) for filing your tax
return for the year of the Roth Conversion. Thus, your executor could undo your Roth
Conversion. For example, assume Husband and Wife convert to a Roth IRA in 2010. In January of
2011, Husband dies and Wife is appointed executor of his estate. Assuming the due date to file
Husband’s final income tax return has not been extended, Wife, as executor, may
recharacterize the Roth Conversion by April 15, 2011.
Conversion of Qualified Plans
In addition to contributing directly to a Roth IRA or converting a traditional IRA, in some
instances individuals may be able to convert their qualified retirement plan benefit to a Roth
IRA. Prior to the passage of the Pension Protection Act of 2006, a Roth IRA could only accept
rollover contributions from another Roth IRA or from another designated Roth account known as a
Roth 401(k) or Roth 403(b). Today, qualified plan assets, including those from non-Roth
401(k), 403(b) and 457(b) plans, can be converted directly to a Roth IRA. In most cases, the
assets rolled over from these plans will be attributed to pre-tax contributions. If so, the
conversion process outlined above will apply. To the extent some of the assets are attributable to
after-tax contributions, these after-tax assets can be rolled over tax-free.
The ideal candidates for qualified plan rollovers into Roth IRAs are usually individuals
who will not need to take distributions from the Roth IRA for many years or who will not take
distributions at all. As outlined above, assets withdrawn within five years of conversion or
before you reach age 591/2 are not qualified distributions and, thus, will be taxed unless an
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exception applies. The normal minimum distribution requirements applicable to qualified plan
benefits upon attainment of age 701/2 generally do not apply to Roth IRAs, except for certain
inherited Roth IRAs.
There is 20% mandatory withholding on rollover distributions paid to you or your spouse.
However, direct trustee-to-trustee rollovers into a Roth IRA are not subject to 20% withholding, so
it is best to do a direct transfer. Nonspouse beneficiaries can also directly roll over amounts into
a Roth IRA and thereby avoid mandatory withholding. In fact, for nonspouse beneficiaries to take
advantage of a Roth IRA, they must do a direct transfer.
One thing to note: distributions from a qualified plan normally commence when you have
terminated employment. Consequently, in many cases you may have to wait until termination of
employment to rollover amounts into a Roth IRA. Some qualified plans, however, permit inservice distributions. If so, these amounts may be rolled over into a Roth IRA. But even for
qualified plans that permit in-service distributions, there may be plan-imposed restrictions on
which types of contributions are distributable in-service. For example, employee pre-tax elective
deferrals may be distributable while still employed under a given plan, but not employer
matching or profit-sharing contributions or vice-versa. There is some concern in Congress that
employers may terminate 401(k) plans in order to grant employees access to elective deferrals
for rollovers to Roth IRAs. This may cause Congress to enact new legislation permitting a
more flexible conversion opt ion for 401(k) plans. You should consult wit h your
human resources representative or plan administrator to determine how your particular plan
addresses in-service distributions.
Next Steps
In deciding whether to incorporate a Roth IRA into your personal income tax plan, you
should contact your tax advisor as to the tax implications and your financial advisor as to the
financial implications under your circumstances. For more information regarding this matter,
please feel free to contact Matthew S. Beard at 214-953-5848 or mbeard@jw.com, Tyler S.
Andersen at 512-236-2007 or tandersen@jw.com, Jim Griffin at 214-953-5827 or
jgriffin@jw.com, or any member of the Jackson Walker wealth planning or employee benefits
sections, which you may find at www.jw.com.
Wealth Planning
Samuel S. Allen 325.481.2558 sallen@jw.com
Michael J. Baldwin 512.236.2355 mbaldwin@jw.com
Matthew S. Beard 214.953.5848 mbeard@jw.com
M. Keith Branyon 817.334.7235 kbranyon@jw.com
Karina C. Cantu 210.978.7713 kcantu@jw.com
Mark Comuzzie 210.228.2426 mcomuzzie@jw.com
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R. Thomas Groves, Jr. 214.953.5813 tgroves@jw.com
Sam K. Hildebrand 512.236.2064 shildebrand@jw.com
Eric G. Hoffman 210.978.7725 ehoffman@jw.com
William H. Hornberger 214.953.5857 whornberger@jw.com
Michael L. Kaufman 214.953.5734 mkaufman@jw.com
John J. Klein 214.953.5817 jklein@jw.com
Erin N. Tuggle 512.236.2065 etuggle@jw.com
Employee Benefits and Executive Compensation
Tyler S. Andersen 512.236.2007 tandersen@jw.com
Chuck Campbell 512.236.2263 ccampbell@jw.com
James R. Griffin 214.953.5827 jgriffin@jw.com
Nathan T. Smithson 214.953.5641 nsmithson@jw.com
The statements contained herein are not intended to and do not constitute an opinion as to
any tax or other matter. They are not intended or written to be used, and may not be relied upon, by
any person for the purposes of avoiding penalties that may be imposed under any Federal tax law
or otherwise.
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