The most frequent question that our office is fielding these days is "should I convert all or part of my traditional IRA to a ROTH IRA?".
Sounds like a simple question, but it is as much analytical, as it is political and largely depends on your current assets and budget; retirement horizon and assets supporting your pending retirement.
Currently, taxpayers can convert from a tradtional IRA and qualified retirement accounts, to a ROTH IRA as long as their adjusted gross income is under $100,000. In 2010 and subsequent tax years, the $100,000 gross income ceiling is eliminated, opening the conversion possibilities into unprecedented opportunities.
In a nutshell, here's how it works. The amount converted to a ROTH is considered ordinary income in the year of conversion. However, for 2010 only, you can elect to defer half of your tax liability to 2011 and the other half to 2012. One catch, the tax liability is based on tax rates in effect in 2011 and 2012, not those in effect in 2010. The low tax rates that we enjoy today are already set to expire in 2010. Notwithstanding a tax law change by the current administration, 2011 and following tax rates are set revert to those high rates in effect in 2001.
Why convert retirement assets to a ROTH? Here are a few reasons to consider...
1. Current market still provides a low-cost conversion:
Since retirement accounts generally grow tax deferred, you or your heirs will eventually pay tax on the value of these accounts over time in the form of withdrawals. It is entirely possible that your retirement account suffered a large decrease in valuation over the last year, so 2010 may be the ideal time to pay taxes on the conversion on a depressed portfolio and at lower tax rates in 2010. No worries, if the ROTH conversion continues to loose value after the conversion, you can recharacterize back to a traditional IRA up to the tax filing deadline, plus extensions.
2. Social security planning:
Under current law, up to 85% of Social Security Benefits are taxable. Although, tax-exempt income is included in this calculation, ROTH distributions are not. Therefore, supplementing your retirement income with a ROTH, may be beneficial in mangaging the taxability of Social Security benefits.
3. Grossing up the value of retirement accounts:
By converting the account in its entirety and paying the taxes due upon conversion using funds outside of the converted IRA, leaves a larger balance to accumulate over time. Future withdrawals will then be based on a larger account value and completely tax free, providing the conversion met the stipulated holding period.
.
4. Tax diversification:
Outside of municipal bond investments, very few grow tax free. As tax rates increase, it will become advantageous to have non-taxable funds to draw from to supplement retirement income and assist in keeping retirees in a lower tax bracket.
5. Hedge against increasing income tax rates:
Considering the costs of the stimulus, several bailouts and rising deficits, its tough to envision that today's historical low tax rates will carry into the future. We have already mentioned that today's rates are currently scheduled to sunset at the end of 2010 (nothwithstanding future legislation). Thus, in 2011, rates revert to those higher rates in effect in 2001. For those who believe that rates are going up, a conversion allows one to lock in today's low rates while account values are low due to market conditions.
6. Tax loss harvesting:
There are occassions when the recognition of income, releases tax losses, certain carryovers and credits that have been suspended and carried over and may be about to expire. The ROTH conversion helps taxpayers realize favorable tax attributes by increasing the taxpayers ordinary income by the conversion amount which allows all or the majority of the prior years carryovers, credits or losses, to offset the ROTH conversion income. This results in the payment of little or no income taxes on the conversion.
7. Tax-free stretch (Legacy planning):
If the intent to is pass your IRA onto your beneficiary (ies), then conversion to a ROTH is most compelling as the conversion allows the beneficiaries of the IRA to stretch the account and grow tax- free over their lifetime (s).
8. Reduce taxable estate:
For those that intend on leaving a significant amount of retirement assets to their children and other heirs, it may make sense to convert t a ROTH and pay the taxes due while the owner is still living. Not only does the payment of taxes due upon conversion decrease the overall size of the estate; it may result in an overall lower tax burden for all parties involved.
9. Trust planning:
If the purpose of the trust is to hold retirement assets long-term and provide risk protection against the beneficiary (ies) creditors and spendthrift behavior, it may make sense to convert to a ROTH, pay the taxes at the individuals lower tax rate, since trusts are taxed at the highest marginal tax rate and allow the assets to be paid to the trust income tax -free.
Not yet mentioned is that it may make sense to convert a partial amount in the context of marginal tax planning.
We are sure that there are many more reasons where it makes sense to convert. The bottom line is that every individual situation is different and must be analyzed within the context of that individuals current assets, tax position and financial goals for future accumulation, retirement and eventual distribution planning.
Our office is currently involved with many of you in determining if a conversion to a ROTH is feasible, and if so, we move on to determine the amount and when the conversion should take place.
The rules and various aspects of planning are quite involved. The intention of this article is to bring awareness to the many considerations in this area, and is not intended to be a guide in the absence of tax counsel.
