Why convert?
Planning for retirement is more important and challenging than ever in today's economic climate, so it's not surprising that we've seen a lot of interest in this topic. Beginning in 2010, there are more options than ever before for many clients. Due to the Tax Increase Prevention and Reconciliation Act of 2006 (TIPRA), 2010 is the first year that the $100,000 modified adjusted gross income limit for Roth conversions will no longer apply. Additionally, the filing status limitations on the ability to convert to a Roth IRA no longer apply. A Roth account has some important characteristics that can make it especially advantageous.
Roth IRA advantages include:
Many taxpayers cannot contribute directly to a Roth IRA because of the income limits that still apply to direct contributions to a Roth IRA account. For 2010, the Roth contribution limit is phased out for modified AGI in the following ranges:
Because many taxpayers are phased-out of the ability to make an annual Roth IRA contribution, having the option to contribute to a traditional IRA and later convert to a Roth allows most taxpayers the option to obtain the tax advantages of a Roth IRA.
IMPORTANT NOTE: The discussion below is applicable to federal income tax returns. For state and local returns, these rules generally do not apply, but state conformity with federal law for 2010 conversions varies from state-to-state.
For 2010 only, Roth conversions are not included in taxable income of the conversion year. Thus, a 2010 conversion to a Roth IRA is not taxed at all on the 2010 tax return. Instead, the taxable income from the conversion will be reported over a two year period. One-half of the income will be reported in 2011 and the remaining half will be reported in 2012. After 2010, the two-year tax deferral opportunity will not be available. Post-2010 conversions will be taxed in the year of the conversion.
Because 2010 is the first year many higher income taxpayers will be eligible to convert and is the only year the special two-year tax deferral is available, we're expecting to see a substantial increase in Roth conversions this year.
Election to include conversion in 2010 income. Taxpayers may elect to pay the tax on a 2010 conversion with their 2010 tax return rather than deferring the tax until 2011 and 2012. This may make good economic sense depending upon the circumstances of the client.
One consideration is the effective tax rate that will apply when the conversion is taxed. Both federal and state tax rates remain at relatively low levels for 2010. If tax rates increase in 2011 or 2012, the benefit of the two-year tax deferral on the conversion could be substantially reduced or possibly eliminated entirely. Rather than dealing with the uncertainty of what the future may hold, individuals may choose to pay tax on the conversion on their 2010 return.
On the other hand, individuals who do not expect to have as much taxable income in 2011 or 2012 as expected in 2010 will often be better off waiting to pay the tax in the later years. This may apply to individuals who plan to retire in the next year or two, for example.
When must the election to pay the tax with the 2010 return be made? The last date to make the election generally depends on whether the taxpayer requests extension of the filing due date of the 2010 return, as follows:
Note: A refund of a 2010 overpayment can be requested when the 2010 return is filed. However, the taxpayer may also want to apply part of the overpayment to the next year if half of the conversion income will be taxable in 2011.
Do these rules apply to conversions from employer plans to a Roth IRA? A conversion can be made by direct rollover from an employer retirement plan to a Roth IRA for a taxpayer who has separated from service with the employer sponsoring the plan. However, because there's no automatic withholding on direct rollovers, taxpayers must plan for the increased federal and state tax liability to avoid estimated tax penalties if they are not going to defer the tax to 2011 and 2012.
Individuals who are still working for the employer that sponsors their retirement plan cannot roll over their interest in the employer retirement plan to take advantage of the 2010 conversion rules. However, many employers offer Roth 401(k) or Roth 403(b) options that allow employees to defer compensation directly to a designated Roth account. Check with your employer to see if you can take advantage of this option.
Individuals who are at least age 70 ½ must take their required minimum distribution (RMD) for the year before completing a rollover or conversion. A qualified employer plan will not allow the RMD for the current year to be directly rolled into a Roth IRA.
However, clients who convert from one or more traditional IRA accounts may not realize they still need to take their RMD. If the individual converts their entire traditional IRA balance to a Roth IRA without first taking the annual RMD, there will be an excess contribution in the Roth account equal to the RMD. This will result in a six percent excise tax until the excess is distributed.
It's best to avoid income tax withholding on a Roth conversion from a traditional IRA so that the entire amount transferred from the traditional IRA to the Roth will be included in the conversion. Otherwise, IRA funds will be used to make tax payments rather than as savings for retirement. If IRA funds are used to pay the tax, the value of the conversion is significantly reduced and the amount withheld will be subject to tax, and perhaps the 10% early distribution penalty.
Another consideration is the possibility of a recharacterization of a conversion on which income tax has been withheld. If the taxpayer decides to undo the conversion, any withholding will not be available for recharacterization. Unless the taxpayer in this situation can make up the shortfall from other funds part of the converted amount will be subject to tax as well as the premature distribution penalty.
Why recharacterize a Roth conversion? When an IRA is converted to a Roth account, the tax on the conversion is based upon the fair market value of the account on the date of the conversion. Although the value of the converted account could easily decline after the conversion, the taxpayer will still be taxed based upon the value on the conversion date. If there is a significant drop in value after conversion, the taxpayer could end up with a large tax liability but little to show for it in terms of retirement savings. In situations where the Roth IRA loses significant value, the taxpayer should consider recharacterizing some or all of the converted amount back to a traditional IRA. In other cases, the taxpayer may change their mind about the conversion for other reasons. To undo the conversion, the total amount converted can be recharacterized back to a traditional IRA.
By recharacterizing, the amount transferred back to the traditional IRA will be treated as if it was never converted. A taxpayer can recharacterize no later than the extended due date for filing their individual tax return for the conversion year (i.e., by October 15th of the following year).
If the two-year deferral is used to report a taxpayer's 2010 conversion, distributions from the Roth IRA account taken before 2012 will accelerate the income taxes on the conversion. A 2010 distribution from the Roth account will cause the amount of the distribution to be included in taxable income for 2010.
Summary
Many higher-income taxpayers will consider a Roth conversion in 2010 due to the elimination of the income and filing status limits. Because the after-tax accumulations will be tax-free after conversion, the sooner a taxpayer converts the longer the Roth IRA will have time to work for the taxpayer's benefit. Although a Roth conversion isn't for everyone, most taxpayers should consider the benefits of a Roth IRA long before reaching retirement age.
Planning for retirement is more important and challenging than ever in today's economic climate, so it's not surprising that we've seen a lot of interest in this topic. Beginning in 2010, there are more options than ever before for many clients. Due to the Tax Increase Prevention and Reconciliation Act of 2006 (TIPRA), 2010 is the first year that the $100,000 modified adjusted gross income limit for Roth conversions will no longer apply. Additionally, the filing status limitations on the ability to convert to a Roth IRA no longer apply. A Roth account has some important characteristics that can make it especially advantageous.
Roth IRA advantages include:
- Tax-free accumulation of earnings
- Tax-free distributions
- Distributions are not required during the owner's life
- Possible estate tax advantages
Many taxpayers cannot contribute directly to a Roth IRA because of the income limits that still apply to direct contributions to a Roth IRA account. For 2010, the Roth contribution limit is phased out for modified AGI in the following ranges:
- $167,000-$177,000 (MFJ)
- $105,000-$120,000 (Single, HH, MFS living apart from spouse)
- $0 -$10,000 (MFS living together some part of the year)
Because many taxpayers are phased-out of the ability to make an annual Roth IRA contribution, having the option to contribute to a traditional IRA and later convert to a Roth allows most taxpayers the option to obtain the tax advantages of a Roth IRA.
What's so special about 2010?
IMPORTANT NOTE: The discussion below is applicable to federal income tax returns. For state and local returns, these rules generally do not apply, but state conformity with federal law for 2010 conversions varies from state-to-state.
For 2010 only, Roth conversions are not included in taxable income of the conversion year. Thus, a 2010 conversion to a Roth IRA is not taxed at all on the 2010 tax return. Instead, the taxable income from the conversion will be reported over a two year period. One-half of the income will be reported in 2011 and the remaining half will be reported in 2012. After 2010, the two-year tax deferral opportunity will not be available. Post-2010 conversions will be taxed in the year of the conversion.
Because 2010 is the first year many higher income taxpayers will be eligible to convert and is the only year the special two-year tax deferral is available, we're expecting to see a substantial increase in Roth conversions this year.
Election to include conversion in 2010 income. Taxpayers may elect to pay the tax on a 2010 conversion with their 2010 tax return rather than deferring the tax until 2011 and 2012. This may make good economic sense depending upon the circumstances of the client.
One consideration is the effective tax rate that will apply when the conversion is taxed. Both federal and state tax rates remain at relatively low levels for 2010. If tax rates increase in 2011 or 2012, the benefit of the two-year tax deferral on the conversion could be substantially reduced or possibly eliminated entirely. Rather than dealing with the uncertainty of what the future may hold, individuals may choose to pay tax on the conversion on their 2010 return.
On the other hand, individuals who do not expect to have as much taxable income in 2011 or 2012 as expected in 2010 will often be better off waiting to pay the tax in the later years. This may apply to individuals who plan to retire in the next year or two, for example.
When must the election to pay the tax with the 2010 return be made? The last date to make the election generally depends on whether the taxpayer requests extension of the filing due date of the 2010 return, as follows:
- Unextended return: April 15, 2011
- If the election is made, pay the tax with the 2010 return
- Extended return:
- Earlier of:
- When the return is filed
- October, 15, 2011 (last date to file extended return)
- Any anticipated tax liability should be paid by April 15, 2011 just in case the election to the pay the tax with the 2010 return is made.
- Payment of tax by April 15 preserves the ability to elect to report the conversion on the 2010 return.
- If the election is not made, a refund of the 2010 overpayment can be made when the return is filed.
Note: A refund of a 2010 overpayment can be requested when the 2010 return is filed. However, the taxpayer may also want to apply part of the overpayment to the next year if half of the conversion income will be taxable in 2011.
Rollovers from qualified employer retirement plans
Do these rules apply to conversions from employer plans to a Roth IRA? A conversion can be made by direct rollover from an employer retirement plan to a Roth IRA for a taxpayer who has separated from service with the employer sponsoring the plan. However, because there's no automatic withholding on direct rollovers, taxpayers must plan for the increased federal and state tax liability to avoid estimated tax penalties if they are not going to defer the tax to 2011 and 2012.
Individuals who are still working for the employer that sponsors their retirement plan cannot roll over their interest in the employer retirement plan to take advantage of the 2010 conversion rules. However, many employers offer Roth 401(k) or Roth 403(b) options that allow employees to defer compensation directly to a designated Roth account. Check with your employer to see if you can take advantage of this option.
Don't forget required minimum distributions (RMDs)
Individuals who are at least age 70 ½ must take their required minimum distribution (RMD) for the year before completing a rollover or conversion. A qualified employer plan will not allow the RMD for the current year to be directly rolled into a Roth IRA.
However, clients who convert from one or more traditional IRA accounts may not realize they still need to take their RMD. If the individual converts their entire traditional IRA balance to a Roth IRA without first taking the annual RMD, there will be an excess contribution in the Roth account equal to the RMD. This will result in a six percent excise tax until the excess is distributed.
Tax Withholdings or Estimated Tax Payments
It's best to avoid income tax withholding on a Roth conversion from a traditional IRA so that the entire amount transferred from the traditional IRA to the Roth will be included in the conversion. Otherwise, IRA funds will be used to make tax payments rather than as savings for retirement. If IRA funds are used to pay the tax, the value of the conversion is significantly reduced and the amount withheld will be subject to tax, and perhaps the 10% early distribution penalty.
Another consideration is the possibility of a recharacterization of a conversion on which income tax has been withheld. If the taxpayer decides to undo the conversion, any withholding will not be available for recharacterization. Unless the taxpayer in this situation can make up the shortfall from other funds part of the converted amount will be subject to tax as well as the premature distribution penalty.
Undoing a conversion by recharacterization back to a traditional IRA
Why recharacterize a Roth conversion? When an IRA is converted to a Roth account, the tax on the conversion is based upon the fair market value of the account on the date of the conversion. Although the value of the converted account could easily decline after the conversion, the taxpayer will still be taxed based upon the value on the conversion date. If there is a significant drop in value after conversion, the taxpayer could end up with a large tax liability but little to show for it in terms of retirement savings. In situations where the Roth IRA loses significant value, the taxpayer should consider recharacterizing some or all of the converted amount back to a traditional IRA. In other cases, the taxpayer may change their mind about the conversion for other reasons. To undo the conversion, the total amount converted can be recharacterized back to a traditional IRA.
By recharacterizing, the amount transferred back to the traditional IRA will be treated as if it was never converted. A taxpayer can recharacterize no later than the extended due date for filing their individual tax return for the conversion year (i.e., by October 15th of the following year).
Distributions related to 2010 conversions
If the two-year deferral is used to report a taxpayer's 2010 conversion, distributions from the Roth IRA account taken before 2012 will accelerate the income taxes on the conversion. A 2010 distribution from the Roth account will cause the amount of the distribution to be included in taxable income for 2010.
Summary
Many higher-income taxpayers will consider a Roth conversion in 2010 due to the elimination of the income and filing status limits. Because the after-tax accumulations will be tax-free after conversion, the sooner a taxpayer converts the longer the Roth IRA will have time to work for the taxpayer's benefit. Although a Roth conversion isn't for everyone, most taxpayers should consider the benefits of a Roth IRA long before reaching retirement age.