While much has been written about the new possibilities of converting traditional IRAs to Roth IRAs in 2010, advisers should not lose sight of the possible benefits of moving the timing up a year.
While 2010 will mark the first time that many higher-income individuals will have easy access to a Roth IRA because of the elimination of the $100,000 income threshold for conversions, the recession may make the conversion available in 2009. Many owners of passthrough entities will see their 2009 income reduced dramatically because of business losses. Even if the adviser cannot be sure that modified AGI will be less than $100,000, consideration should be given to making the conversion and then reversing the transaction if the individual is found to be ineligible for it later.
Converting in 2009
If eligibility for making a conversion is in doubt for 2009, it may be helpful to review the rules for determining modified AGI for the income test. Sec. 408A(c)(3)(C) says that modified AGI for Roth IRA conversion purposes is calculated in the same manner as set forth in Sec. 219(g)(3)(A), which is used to test the eligibility to make deductible IRA contributions. Modified AGI as set forth there is used for limiting the deduction for IRA contributions.
Under Sec. 219(g)(3)(A), modified AGI is determined:
- By taking into account:
- Taxable Social Security and railroad retirement benefits; and
- The passive loss rules under Code Sec. 469; and
- By disregarding:
- The IRA deduction itself;
- The exclusion for savings bond proceeds used to pay higher education expenses (under Sec. 135);
- The exclusion for adoption assistance provided by the employer under an adoption assistance program (under Sec. 137);
- The domestic production activities deduction (under Sec. 199);
- The deduction for interest paid on a qualified education loan (under Sec. 221);
- The deduction for higher education expenses (under Sec. 222); and
- The foreign earned income exclusion and the housing cost exclusion for U.S. citizens living abroad (under Sec. 911).
These rules are further discussed in Regs. Sec. 1.408A-4 in Q&A format. The regulations point out that if the taxpayer is married, he or she must file a joint tax return. In other words, modified AGI must be determined on a joint filing basis. However, a taxpayer who has not lived with his or her spouse for the entire tax year can be treated as unmarried for purposes of this requirement.
The taxable amount involved in a traditional IRA to Roth IRA conversion is not taken into account in calculating modified AGI, including the calculation of phaseouts or other tax provisions based on AGI (e.g., the phaseout of the ability to deduct active participation rental losses based on AGI under Sec. 469).
Therefore, it is important to note that in testing for eligibility, the amount includible in income due to the conversion does not affect the losses allowed, but the conversion income itself may result in a complete elimination of the losses allowed on the tax return. The Tax Court illustrated this concept in a 2002 summary opinion, deciding that income from a conversion caused the inclusion of Social Security benefits in AGI, even though such income was not included in testing for the eligibility of making the conversion itself (Helm, T.C. Summ. 2002-138). Once eligibility is determined, any other tax impact of actually making the conversion must then be considered.
If a taxpayer converts a traditional IRA to a Roth IRA and later discovers that he or she was not eligible, the conversion can be undone by using the recharacterization rules. A trustee-to-trustee transfer of the amount originally converted, plus any income earned since the conversion, must be made back to a traditional IRA account. Generally, the taxpayer must complete the recharacterization by October 15 of the year following the year of the original conversion.
Example 1: A owns 100% of X, an S corporation, and expects 2009 income to include a salary of $100,000 from X, investment income of $25,000, and an ordinary loss of $50,000 from X. A also has a traditional IRA account with a value of $85,000. Because X normally has ordinary income in excess of $100,000, he has not been able to contribute to a Roth IRA account and has not been eligible to convert his IRA account to a Roth IRA. Based on his expected income, A transfers his entire IRA to a Roth IRA in December 2009. X’s accountant discovers adjustments that must be made to X’s accounting during March 2010 that result in X’s ordinary income actually being $100,000 for the year. As long as A transfers all the Roth IRA funds back to a traditional IRA account no later than October 15, 2010, the original conversion can be ignored.
Unfortunately, the recharacterization rules do not allow a reconversion before the later of the first day of the tax year following the tax year of the conversion or the end of the 30-day period beginning on the day of the recharacterization.
Example 2: The facts are the same as in Example 1, and A successfully recharacterizes his failed conversion on July 15, 2010. A would now like to take advantage of the special two-year averaging available for 2010 conversions. The recharacterization rules will allow a reconversion in 2010, but not before August 14, 2010 (Regs. Sec. 1.408A-5, Q&A-9).
Thus, those taxpayers who stand to benefit the most from conversions need to be conservative in their assumptions about 2009 eligibility so they do not lose the benefits of a 2010 conversion.
Who Should Consider a Conversion?
Most advisers agree that the prime candidates for making a conversion are those who have several years left to retirement and especially those who will likely have a taxable estate. Many such taxpayers will never need their retirement savings, and the conversion will provide a way to pass the maximum amount to their heirs. Taxpayers who expect to have an NOL for the year should consider a 2009 conversion, as described above, and this will continue to hold true for later years. Advisers should also encourage taxpayers to consider the conversion strategy in lieu of or, in addition to, any carryback possibilities.
Tax Rates for 2010 Conversions
In most instances, 2010 will still be the first year that conversions will be possible for those with high income levels. While Congress has made the option of a 2010 conversion attractive, there are some issues with which a taxpayer has to be familiar. One of the most appealing aspects of a 2010 conversion, besides not having to estimate modified AGI, is the two-year averaging rule that will result in a deferral of all tax on the 2010 conversion until 2011 and 2012, when 50% of the converted amount will be added to income for each year. However, what tax rates might apply to the income added to 2011 and 2012?
Taxpayers have to remember that the Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16, which rolled back tax rates, included sunset provisions. After 2010, the tax rates provided in that law are repealed, and the rates that applied before then will be applicable once again. As a result, individual tax rates above 15% will be rolled back to 28%, 31%, 36%, and 39.6% (instead of the current 25%, 28%, 33%, and 35%). Further, proposals have been floated during the 2009 congressional sessions to finance health care reform with a surtax on higher levels of income.
This situation makes it appear that the ability to elect out of the averaging provision may be valuable for taxpayers who will have income in 2011 and 2012 in the highest bracket. Therefore, the appeal of the two-year averaging opportunity might be illusory for many high-income taxpayers.
The analysis of whether a taxpayer should undertake a conversion starts with the question of whether the taxpayer can pay the tax liability resulting from the conversion with funds from outside the IRA. This will require the taxpayer to have enough financial flexibility to get the most out of the conversion. Advisers should probably rule out taxpayers who do not have the necessary liquidity.
Next, projections of income should be prepared for the years 2009–2012. Naturally, the further the analysis goes into the future, the more likely it is that the projections become little more than conjecture. However, an adviser must make some assumptions so the taxpayer has some basis on which to make a decision.
Taxes need to be calculated for the years that will likely include the income, including alternates with and without the conversion, as well as with and without tax rate increases.
Based on this analysis, an adviser can prepare estimates of a range of additional taxes for the taxpayer to consider. Further, those taxpayers who likely will have a taxable estate (which itself requires a set of assumptions about growth of the taxpayer’s current net worth, life expectancy, and estate tax rules of the future) should see an adjustment to factor in the estate tax savings that would result from removing the income tax dollars from the taxable estate.
Resistance to the Conversion Suggestion
Advisers should be prepared for questions about why their clients were always encouraged to defer paying tax on their IRA accounts and now are being advised to accelerate the tax. The benefits of making the conversion need to be reviewed and perhaps illustrated, including the opportunities for using stretch planning and setting up multiple IRAs with various beneficiaries. If an adviser feels that the taxpayer is strongly resistant to paying the tax early, that taxpayer may not be a good candidate for conversion.
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
For additional information about these items, contact Mr. Koppel at (781) 407-0300, or firstname.lastname@example.org.