Editor: Stephen E. Aponte, CPA
The Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222 (TIPRA), enacted on May 17, 2006, contained a provision that allows more taxpayers to convert their traditional IRAs to Roth IRAs starting in 2010 (Secs. 408A(c) (3) and (d)(3)(A)(iii)). This could be a huge benefit for some high-income taxpayers that in the past have not been able to make use of the many advantages Roth IRAs have over traditional IRAs.
Roth IRAs originated with the Taxpayer Relief Act of 1997, P.L. 105-34. They differ from traditional IRAs in a few important respects, including but not limited to the following:
- Contributions to Roth IRAs are never deductible for income tax purposes. Traditional IRA contributions can be.
- Distributions from Roth IRAs can be taken at any time without penalty. Distributions from traditional IRAs before turning age 59½ are generally subject to a 10% penalty.
- Unlike with traditional IRAs, individuals are not required to take minimum distributions from a Roth IRA when they turn age 70½.
- Distributions from Roth IRAs are generally tax free. Any tax-deferred portion of a traditional IRA distribution is subject to ordinary income tax.
- Roth IRA contributions can be made by taxpayers only under a certain income amount. (Contributions to Roth IRAs are fully phased out in 2009 at $176,000 for married taxpayers filing jointly and at $120,000 for single taxpayers.) There is no such limitation for traditional IRAs.
The last difference has prevented highincome taxpayers from taking advantage of Roth IRAs. In addition to the income limitation for contributions, there has been an income limitation for rollovers from traditional IRAs to Roth IRAs. Taxpayers with modified adjusted gross income (AGI) greater than $100,000 are precluded from making such rollovers. For this purpose, modified AGI is defined as it is for traditional IRA purposes, but it does not include income from the conversion. It also does not include any required minimum distribution from an IRA (Sec. 408A(c)(3)(C)(i); Regs. Sec. 1.408A-5). Rollovers made from a traditional IRA to a Roth IRA are subject to ordinary income tax but are exempt from the 10% early withdrawal penalty.
Changes for 2010
For tax years beginning after 2009, the $100,000 modified AGI limit for conversions has been eliminated. In addition, taxpayers with a filing status of married filing separately, who have previously been precluded from making such conversions, will be able to do so (Sec. 408A(c)(3)).
For conversions made in 2010 only, none of the income from the conversion will be recognized in that year; it will be recognized in two equal parts in 2011 and 2012. If the taxpayer elects to do so, he or she may recognize 100% of the income in 2010 instead (Sec. 408A(d)(3)(A)).
This raises a very interesting planning problem. It is unclear at this point what the tax rates will be beyond 2010. Unless new legislation is enacted, the tax brackets above 15% will revert to their pre-2001 levels. That means the highest rate will rise from the current 35% to 39.6%. Under those circumstances, it may be beneficial to pay the tax earlier but at a lower rate. Keep in mind that for those not in the highest bracket, the conversion amount, when added to income, could put the taxpayer into a higher tax bracket.
Roth IRA conversions may not be for everyone. In general they make the most sense in the following situations:
- The taxpayer is able to pay the tax due on the conversion from outside funds. If the taxpayer must withdraw funds from his or her IRA to pay the tax, there will be less in the account to grow tax free.
- The taxpayer has a number of years until retirement. This allows more time for the money to grow tax free and offsets the fact that the tax is being paid up front.
- It is expected that the taxpayer’s future marginal rates will be higher than they are now, either because his or her income will be higher at that time or because rates in general will be higher.
- The taxpayer does not foresee a need to live on IRA withdrawals. Because Roth IRAs have no minimum distribution requirements, they can grow tax free even after the taxpayer turns 70½.
Although these changes take effect in 2010, taxpayers can start to plan for them now. Those eligible to make deductible IRA contributions can do so in 2009 and take a tax deduction for them. They can then roll that amount over to a Roth IRA in 2010 and pay the tax in 2011 and 2012. Those not eligible can still make a nondeductible contribution in 2009. When the nondeductible IRA is converted to a Roth IRA in 2010, only the earnings in the account will be subject to tax. It is important to note that those with both deductible IRAs and nondeductible IRAs cannot choose to roll over only the nondeductible amounts. The amounts must be prorated based on the balances of each type.
The new law presents a terrific opportunity for some taxpayers to convert their existing IRAs into Roth IRAs. Planning should start now and should look at each taxpayer’s situation individually over a long time horizon. It is important to determine not only if a conversion makes sense but, if it does, whether the taxpayer should pay the tax in 2010 or spread it out over the following two years. When conversion does make sense, the taxpayer can save a significant amount of tax over his or her lifetime.
Stephen Aponte is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
For additional information about these items, contact Mr. Aponte at (212) 792-4813 or firstname.lastname@example.org.