Advantages to Converting to a Roth IRA in 2010
2011 is the first year that taxpayers with more than $100,000 of income can convert to a Roth IRA. 2011 may also be the best year for taxpayers to do a Roth IRA conversion because of the scheduled tax increases in future years. In addition, after 2010, increasing income could cause a person’s investment income and wages to be subject to the new health care taxes.
When a traditional IRA is converted to a Roth, all before-tax contributions made to the IRA become taxable; and the income tax must be paid. But once the money is in the Roth IRA, it grows tax-free; and the Roth IRA owner can make tax-free withdrawals at any time provided that five years has passed. For a Roth IRA, there are no minimum required distributions after you attain age 70½. This can be a tremendous advantage – tax-free growth and no minimum required distributions.
For estate planning purposes, transferring a Roth IRA to your beneficiaries on your death can be a very valuable opportunity. The beneficiary has an asset which will grow at a compounded rate tax-free for his/her lifetime, and any withdrawals made will be completely tax-free. There is simply nothing else like it. No other investment will give this kind of return tax-free. Inheriting a Roth IRA is much more valuable than inheriting any other asset. Note that the IRA is still subject to Inheritance Tax and Federal Estate Tax at the owner’s death.
For Roth conversions in 2010, taxpayers have a choice. The amount withdrawn from the IRA can be reported as part of 2010 income, or, one-half can be added to income in 2011 and one-half in 2012. Conversions in 2011 and thereafter are included in income during the tax year in which the conversion is completed. Many taxpayers plan to choose taxation in 2010 because of the near certainty of higher income tax rates in 2011. Also, if a taxpayer can avoid the alternative minimum tax (AMT), paying the year’s projected state income tax liability (if you are in a state – not Pennsylvania – that taxes IRA income) by December 31, 2010 is a good idea so that the deduction for state taxes can help offset the income from the conversion. Consideration should be given to making immediate additional estimated tax payments in the quarter the taxpayer anticipates doing the conversion.
Remember, there is an “undo” available if hindsight shows that decision was not a good one. The return can be amended and/or the Roth can be “put back” into a traditional IRA with a re-characterization. In most cases this can be accomplished any time up to October 15 of the year following the conversion.
Here are some descriptions of good candidates for a Roth IRA conversion.
● Someone who will always be in the highest income tax bracket. Then the additional income from the conversion will not be pushing you into a higher bracket. The maximum rate of 35% in 2010 is an historic low. At this point we’re looking at 39.6% in 2011, 2012 and 43.4% in 2013 unless Congress takes some action to change it.
● Someone whose estate will be subject to the federal estate tax. Right now it looks very possible that the federal estate tax exemption in 2011 will revert to only $1 million. Getting the income tax out of the estate by paying it before death is good planning. Giving a beneficiary an asset with tax-free growth and income is a great advantage.
● Someone who is in a low bracket now but likely to be in a high bracket at retirement, or someone who now lives in a state with no income tax but is likely to retire to a state that does have an income tax.
● Someone planning a large charitable contribution in 2010 or with a charitable deduction carryforward that is going to expire in 2010. If you cannot take a full deduction for your charitable contribution, you can carry forward the excess to up to five succeeding years. With additional income from the conversion raising the charitable deduction limitation, this can be a part offset for the income that the Roth conversion generates.
● Someone who doesn’t want to take required minimum distributions (MRDs). Once the tax is paid, there is no rule that forces a Roth owner to take out distributions on a schedule. The assets can stay inside the Roth and continue to accumulate tax free. Note that when the owner dies and a beneficiary owns the Roth, the beneficiary does have to take MRDs, but those withdrawals can be stretched out over the lifetime of the beneficiary.
● Someone who can pay the additional income generated by the conversion with non-IRA assets. If you pay the taxes from the assets in your traditional IRA, you reduce the amount that will be able to grow tax-free in the Roth IRA. If you withdraw money from your IRA to pay income taxes due on conversion, that amount is treated as a distribution and thus subject to income tax and a 10% IRS penalty if you are under age 59½.