2010: The Year of the Roth Conversion Opportunity

By Kenneth H. Bridges, CPA, PFS     January 2010

Prior to 2010, the ability to convert a traditional IRA to a Roth IRA was limited to those with income below $100,000.  Effective January 1, 2010, taxpayers can convert their traditional IRAs to Roth status, regardless of their income level.  This rule change represents a potentially substantial tax savings opportunity; or a potentially substantial tax detriment, depending on your personal circumstances and future tax laws.  Accordingly, it is important that everyone carefully consider the possibility of a Roth conversion during 2010. Even if you do not presently have any significant amount of money in an IRA, don’t stop reading yet; the matters discussed in this article may be very pertinent to you because of the potential applicability to amounts in qualified plans (e.g. 401(k) plans) or because of the potential benefit of making an initial contribution to a Roth IRA now.

With a traditional deductible IRA, 401(k) or other qualified retirement plan, you get an income tax deduction (or W-2 exclusion) on the front end when the money goes into the plan, the inside build-up is tax-deferred, and then you pay tax on distributions when taken (generally during retirement).  There is no penalty on the distributions, so long as you are at least age 59 ½ when you take the distribution, and you must begin taking distributions at age 70 ½. The value of the account at your death is included in your taxable estate (unless left to charity), and your beneficiaries pay income tax on the distributions when they receive them.  To the extent any estate tax was paid on the value of the IRA or qualified plan, your heirs get an income tax deduction for such over the distribution period.

Legislation enacted in 1997 introduced a new type of IRA, the “Roth”. With the Roth IRA, you get no deduction on the front end, but you pay NO tax on the distributions. This is much more advantageous than a traditional NON-deductible IRA, whereby you get no deduction on the front end but then distributions are taxable to the extent of the earnings.  The required minimum distribution rules do not apply to a Roth during the owner’s lifetime (they take effect after death, and apply with respect to the beneficiaries).  As with a traditional IRA or qualified plan, the value of the Roth is included in the owner’s taxable estate at death (unless left to charity).  The beneficiaries, however, do not incur any income tax on distributions.

Income limitations on who can contribute to a Roth and contribution limits on the amount that can be contributed to a Roth have made it difficult for most taxpayers to get significant dollars into a Roth (if any at all).  Rules enacted effective beginning with 2006 permitted employers to add a Roth feature to 401(k) plans, which has enabled taxpayers to get somewhat more money into Roths.  However, the primary method for getting significant dollars into a Roth is to convert money from a traditional IRA or qualified plan into a Roth IRA.  The conversion is a taxable event, but, in the right circumstances, can be very beneficial over the long-term.

Prior to 2010, the ability to convert to a Roth was limited to those whose income for the year of conversion was otherwise less than $100,000.  This income-based limitation shut out some of those who might have most benefited from conversion.  Effective January 1, 2010, however, anyone can convert to Roth status, regardless of income level.  Further, for conversions taking place in 2010, you have the option of either recognizing the resulting income on your 2010 tax return, or spreading it over 2011 and 2012.

The primary factors for consideration in making the Roth conversion decision are:

Creditor protection – Amounts in qualified plans subject to ERISA enjoy great protection from creditors.  Amounts in IRAs may enjoy somewhat similar, but generally not as complete, protection under Federal bankruptcy law or state laws.  If you need the more complete creditor protection of ERISA, then taking money out of an ERISA plan for purposes of doing a Roth conversion may not be advisable.  On the other hand, if you can get sufficient creditor protection for your IRA money under applicable state law, then converting to Roth status may represent a means to effectively creditor protect even more money (i.e. you will have removed from the reach of your creditors the money otherwise needed in the future to pay tax on IRA distributions).
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Charitable intentions – IRAs and qualified plan money can be good assets to leave to charity.  To the extent you name a charity as the beneficiary, the amount is excludable from your taxable estate and the amount also escapes income tax.  Accordingly, if you plan to leave your IRA to charity you would not want to make a Roth conversion.

Other Considerations:

Not an all or nothing decision – You have the ability to choose the amount you convert.

Assets in a qualified plan – While you cannot do a Roth conversion inside a qualified plan (e.g. 401(k) plan), you can roll amounts from a qualified plan to a Roth IRA; assuming that your plan permits such.

Getting the 5-year clock running – In order to be completely tax and penalty free, a distribution from a Roth must be made after either age 59 ½, death or disability or for a qualified special purpose; and at least 5 tax years must have lapsed since the first tax year in which the individual made a Roth contribution or did a Roth conversion.  Accordingly, one of the benefits of doing a Roth conversion or contribution of at least some small amount is that it gets the 5-year clock running for any future Roth distribution.

Spread over 2011 and 2012, or recognize in 2010? – A special feature of converting to Roth status during 2010 is that you have the option to either include the conversion amount in your 2010 taxable income or spread it over 2011 and 2012.  In addition to the obvious time-value-of-money benefit of deferring to 2011 and 2012, the greater potential benefit of the 2-year spread is avoiding forcing more of the conversion income into a higher tax rate bracket. Were it not for the possibility of tax rates increasing (which appears likely to be the case), opting for the spread over 2011 and 2012 would likely be the way to go (unless you have expiring tax attribute carryforwards).   Under the circumstances, however, careful analysis will be required to determine which is the better option.

State income tax considerations – It is important not to forget the potential state income tax implications of a Roth conversion, both in terms of the potential conversion tax and a potential change in residency between time of conversion and time of distribution (e.g. do you live in a high income tax state during year of conversion, but with the plan to retire to a state with no income tax or high retirement income exclusions?).

Ability to recharacterize (a “do-over”) – One of the great features of the Roth conversion is that you essentially get a “do-over”.  If you convert to Roth status during the tax year, you have up until the extended due date of your income tax return for that year to decide you want to undo it.  This provides a great opportunity to use some 20/20 hindsight in making the decision.

Sophisticated planning techniques include dividing your IRA into multiple IRAs each invested in a different sector.  The idea being that if a particular sector declines in value between the time of conversion and the deadline for undoing the conversion, then you elect to recharacterize that particular IRA, but not the others.

Risk factors – Might Congress decide in the future to tax Roth distributions, effectively reneging on the implied promise that you have going into the Roth?  Consider that today social security benefits are taxable for those with income over certain threshold amounts.  Or consider the 15% excise tax (“success tax”) that applied for a while during the late 80’s and early 90’s to excess distributions from or excess accumulations in qualified plans.  It is possible.  Or what if the income tax is replaced by a consumption-based tax (e.g. the “Fair Tax”)?  That would really be the ultimate in double taxation; to have paid tax on your IRA or qualified plan money to get it into a Roth, and then effectively be taxed on it again when you take distributions by virtue of a consumption-based tax that has replaced the income tax or an income tax that applies to Roth distributions.  Those with Medicare Part B premiums need to consider that the additional income from a Roth conversion may cause their premiums to increase.

Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.

This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice.  The article provides only a very general summary of complex rules.  For advice on how these rules may apply to your specific situation, contact a professional tax advisor.