The number of Google searches for information about Roth IRA conversions has increased dramatically recently. In fact, search data reveals that the number of people searching for the phrase “Roth IRA conversions” more than tripled between January and November 20091.
This surge in interest about Roth IRA conversions is hardly surprising considering that starting in 2010, all taxpayers, regardless of income, are eligible to convert tax-deferred retirement assets to a Roth IRA. Prior to the change, the law prevented taxpayers with household incomes above $100,000 from converting assets to a Roth IRA.
If you are among the nearly 50% of Americans who believe their own taxes are going to increase, you may be interested in the possibility of a tax-free income that a Roth IRA conversion can bring2.
A Roth IRA is a retirement savings vehicle that differs from tax-deferred retirement accounts such as traditional IRAs and most employer-sponsored retirement plans. With a Roth IRA, you make contributions with after-tax dollars, but qualified withdrawals after age 59 1/2 are tax-free. Aside from the tax benefits, Roth IRAs offer freedom from required minimum distributions. Most employer-sponsored retirement plans and traditional IRAs require that you make annual minimum withdrawals after age 70 1/2. With a Roth, the money can stay in the account indefinitely. This change in the tax law could have far-reaching implications for your retirement income.
It should be noted that there are still annual income limits in place for determining eligibility to contribute to a Roth IRA. The income limitation was eliminated only for conversions.
To qualify for the tax-free and penalty-free withdrawal of earnings and amounts converted to a Roth IRA, the account must be in place for at least five tax years and the distribution must take place after age 59 1/2 or as a result of death, disability or a first-time home purchase ($10,000 lifetime maximum).
Usually, the amount converted to a Roth IRA in any given year is included in your income for tax purposes. The catch is that using tax-deferred assets to pay the income taxes before you reach age 59 1/2 would run afoul of the rule against early distributions and could cost you a 10% federal income tax penalty on the distribution. Generally, the taxes on a Roth conversion should come from non-retirement assets, which could be prohibitive for some people.
Investors who take advantage of a Roth conversion in 2010 have the option of recognizing all the income in 2010 or breaking up the tax bill and paying it over two years, in 2011 and 2012. Consider, for example, a hypothetical investor who converts 100% of assets in a traditional IRA worth $300,000 to a Roth IRA in 2010. He can report all $300,000 as income on his 2010 tax return or can choose to report nothing in 2010. In the latter case, he would report $150,000 of the income on his 2011 tax return and $150,000 on his 2012 tax return.
It is important to note that if you defer the taxes on a 2010 Roth conversion, the half of the tax bill that comes due in 2011 would be subject to 2011 tax rates; the same situation arises in 2012. Because the reduced income tax rates in effect today are scheduled to reset to their pre-2001 rates in 2011, there is a chance that if you spread the tax bill on a conversion over 2011 and 2012, you could pay higher tax rates than if you paid all the taxes in 2010.
IRA expert Ed Slott recently had this to say about Roth conversions: “It is likely that tax rates will increase in future years, making tax-free Roth IRA income more valuable3.”
For many people, recognizing the tax liability that comes with a Roth conversion in 2010 may make sense if their retirement accounts have lost a significant amount of value in the last 18 months (and they don’t need to access the funds for five years). The less money in the account at the time of the conversion, the less tax that must be paid.
Individuals who change their minds after utilizing a Roth IRA conversion can elect a “do over,” called a recharacterization. The assets would be converted back to tax-deferred status and you can file an amended tax return seeking a refund of the income taxes you paid on the conversion. In order to qualify, you must recharacterize the funds before October 15 of the year following the year in which you converted.
Remember, we can’t look into a magic crystal ball and determine if future taxes are going to be higher, or if the dollar is going to continue to be weaker, etc. But, we can make a plan. President John F. Kennedy once said, “The time to repair the roof is when the sun is shining.” While the sun is shining brighter on the markets this year, isn’t that the time to review your retirement strategy going forward?
1 InvestmentNews, November 16, 2009
2 Rasmussen Reports, September 3, 2009
3 www.boston.com, August 11, 2009
Michael Hill is owner and Branch Manager of Hill & Associates, Wealth Advisory Group. Hill & Associates have offices in both Midlothian and Plano, TX. They have been serving investors in the DFW area since 1982. Michael Hill is an IRA Distribution Specialist and was also honored with the prestigious “Five-Star Wealth Manager Award” by Texas Monthly (August, 2009).
