Tax Alert: New IRA-Roth IRA Conversion Rules In Effect for 2010
12/11/2009
The year 2010 marks the beginning of a new era in retirement savings and planning, as well as a new technique for estate planning. Next year, taxpayers will be allowed to convert regular IRAs to Roth IRAs regardless of their Adjusted Gross Income (AGI). The new rules also apply to qualified plan funds that otherwise qualify for a rollover. Through 2009 only taxpayers with an AGI of $100,000 or less could convert amounts held in a traditional IRA to a Roth IRA; married persons filing separately could never convert—until now.
Unlike a traditional IRA, there is no tax deduction for contributions made to a Roth IRA. If you follow all the rules, your after-tax contributions grow completely tax-free and there are no distributions required during your lifetime (the requirement to begin taking annual distributions after attaining age 70 ½ does not apply to Roth IRAs). In addition, there is no early withdrawal penalty on distributions of contributed funds, as long as the distributions are “qualified” ones. (There are penalties for withdrawing the earnings, however). In general, “qualified distributions” cannot be made until the taxpayer attains age 59 ½, dies, or becomes disabled, and cannot be made until the taxpayer has maintained a Roth IRA for at least five tax years (counting the year the Roth IRA was established).
The elimination of the income threshold on the conversion of a traditional IRA to a Roth IRA has several ramifications. With the new rule comes a significant, long-term benefit—you can convert the tax-deferred future growth of an IRA into the tax-free growth of a Roth IRA. However, you must pay taxes presently on the amount you are converting. The rolled-over amount is normally taxable in the year of the rollover. However, for conversions made in 2010, taxpayers can defer the income recognition, reporting one half of the conversion amount in 2011 and the other half in 2012. Couple this “installment option” with the new expanded rules on who can do a Roth conversion, and 2010 may just be the best year to accomplish this. However, the possibility of personal income tax rate hikes in 2011 resulting from the sunset of the Bush tax cuts may make it preferable to report the income resulting from a conversion in 2010.
A Roth IRA conversion can also be a very good estate planning vehicle. This technique makes a lot of sense for someone who doesn’t need the IRA funds during their retirement, and would like to pass on a source of tax-free income to their heirs. Future generations are better off inheriting a tax-free Roth than a traditional IRA or other qualified retirement plan.
Some aspects of Roth conversions that make them attractive from an estate planning perspective are:
- The payment of income tax on the conversion will reduce the size of your taxable estate.
- Since a Roth IRA is not subject to Required Minimum Distributions (or “RMDs”), the Roth dollars can grow tax-free for a longer period of time, providing more wealth for the beneficiaries.
- Beneficiaries of Roth IRAs enjoy tax-sheltered earnings and tax-free withdrawals (unlike a traditional IRA or qualified retirement plan).
However, since beneficiaries are subject to RMDs, they must commence regular withdrawals from the inherited Roth following the owner’s death.
The overall tax benefits of a Roth IRA conversion will be maximized if the tax due on conversion is paid from assets outside the Roth IRA (i.e. from a taxable account). This way, you can save estate taxes, while retaining as much value in the Roth IRA as possible. It is important to remember that the Roth IRA is included in your taxable estate and it is usually better to pay any taxes attributable to the Roth IRA from other assets.
Your tax accountant and wealth management advisor can help you determine if converting your regular IRAs to a Roth IRA is right for your particular situation. They can help you calculate the potential benefit of a tax-free Roth IRA versus a tax-deferred regular IRA, taking into consideration the earnings you will lose as a result of the tax due upon conversion, and whether or not to defer the payment of the taxes attributable to the conversion over two years.
For more information on this and other issues, please contact John Evanich, J.H. Cohn tax partner, or your J.H. Cohn professional at 877-704-3500.
John Evanich, CPA is a partner with J. H. Cohn. John’s areas of specialization within the tax arena are pass-through entities, closely-held businesses, and business succession planning services. John is a nationally recognized instructor on tax issues affecting partnerships, LLCs, LLPs, S corporations and professional services businesses. He may be reached by email or at 860-633-3000.
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