By Jeffrey Gold, CPA

Under a provision of the Tax Increase and Reconciliation Act of 2005 that becomes effective in 2010, anyone (regardless of income) may now convert traditional IRA accounts into Roth IRA accounts. Previously, conversions were only permitted for taxpayers whose income (not including the Roth conversion itself, which adds to income) was not more than $100,000. The new law also includes a one-time special rule that allows taxpayers to delay for up to two years the tax due on Roth conversions that occur in 2010.

Many middle- and higher-income taxpayers who were unable to take advantage of traditional-to-Roth IRA conversions in the past now have a new choice. The elimination of the income threshold to Roth conversions presents a variety of opportunities and risks.

In order to understand this change in the tax law, it is necessary to understand what a Roth IRA is, how it differs from a traditional IRA, and advantages and disadvantages of each type of account. Unlike a traditional IRA, contributions to a Roth IRA cannot be deducted from taxable income. However, the Roth IRA has many positive features not found in traditional IRAs. Foremost among these is that the income earned in the Roth IRA is never taxed. In a traditional IRA, taxation is merely deferred – tax must be paid on all distributions eventually taken. (Even if you die before the account is fully distributed, your heirs will owe income tax when they receive it). By contrast, once you have owned any Roth IRA account for at least five years and are at least 59½ years old you (and your heirs) will never pay tax on distributions from your Roth IRAs, no matter how large they have grown.

The second major benefit is the ability to leave the money in the Roth IRA, earning tax-free income, after you retire. When a taxpayer turns age 70½, he must begin taking required minimum distributions (RMDs) from a traditional IRA based on his life expectancy. There are no RMDs from a Roth IRA, so if the money is not needed for living expenses, the entire balance may continue to compound tax-free in the Roth.

Another difference from traditional IRAs is the ability to continue contributions even past age 70½. This may be a consideration as depleted retirement portfolios cause some individuals to defer retirement. For younger people, Roth IRAs allow withdrawal of original contributions (but not earnings), even before age 59½, with no tax consequences. Since the funds in the Roth IRA will continue to compound tax-free as long they remain there, removing them in this manner should be considered last, and only after all other sources of funds are considered. But if it must be done, at least it will not result in a tax bill when you can likely least afford it.

Whether a Roth or traditional IRA is the better choice depends on many factors. The younger you are, the longer the income of a Roth IRA will compound tax-free, which can dramatically increase the benefits. An older taxpayer may not receive sufficient years of tax-free income to offset the loss of the tax deduction that a traditional IRA can provide. Your expectation of future changes in tax rates may also affect the decision. By forgoing the tax deduction, you effectively choose to pay tax at the current rate. If tax rates increase in the future, you may be locking in a beneficial rate. Conversely, if you will be in a lower tax bracket after you retire than you are now, a traditional IRA may make more sense. A low-income year can also make a Roth IRA advantageous.  For example, if you have a net operating loss, or if your deductions and exemptions exceed your income in a particular year, the deduction provided by a traditional IRA may not save any tax. Contributing instead to a Roth IRA can provide the valuable Roth tax benefits at little or no cost.

For 2009 and 2010, individuals under 50 may contribute up to $5,000 of their compensation each year to an IRA (older taxpayers may contribute $6,000). This contribution can be made to either a traditional or a Roth IRA, or split between both types (as long as the total does not exceed the maximum). Contributions may be made during the year and up until April 15^th of the following year (so 2009 contributions can still be made until April 15, 2010). Certain income limits prevent higher-earning taxpayers from contributing to Roth IRAs. The allowable Roth contribution limit is reduced for joint filers with modified adjusted gross income from $167,000 to $177,000 and single taxpayers from $105,000 to $120,000.  Taxpayers with higher incomes cannot make annual Roth IRA contributions.

Besides annual contributions, another way to fund a Roth IRA is to convert all or any portion of your existing traditional IRA accounts to Roth IRAs. Your IRA custodian can do this quite easily, but it has tax consequences. The amount converted is includible in taxable income in the calendar year the conversion takes place. For example, a taxpayer who lives in New York City may pay a combined tax rate (federal, state, and city) of 45%. Converting a $100,000 traditional IRA to Roth will cost a tax outlay of $45,000. But after the conversion, neither the original $100,000 nor the future earnings on it will ever be taxed. If the taxpayer is 40 when he converts the account, and it returns an average 5%, he will have over $335,000 at age 65 – all of it completely tax-free. If the funds had remained in a traditional IRA, he would have to pay more than $150,000 of tax (assuming rates remain the same) on a distribution of those funds.

 The tax on the conversion is usually paid from funds outside the IRA, and this creates two additional tax advantages. First, it in effect allows the taxpayer to make an extra contribution to his retirement. The taxpayer in the example above will have a $100,000 IRA balance whether or not he converts – but in a traditional IRA, the account is really only worth $55,000 to him since he must pay $45,000 of tax to access it. The Roth IRA is worth the full $100,000, since there is no tax – so by converting he has essentially contributed an extra $45,000 to his IRA. Second, by paying the $45,000 tax to the government it is removed from the taxpayer’s estate for estate tax purposes. If the $100,000 account remained a traditional IRA, the taxpayer would have $145,000 in his taxable estate – the IRA and the $45,000 outside the IRA that he could have used to pay the tax on the conversion. By converting to Roth, the taxpayer owns essentially the same after-tax asset, but his taxable estate contains only the $100,000 Roth IRA. Thus, $45,000 has been removed from his estate, potentially saving $20,000 or more of estate tax.

Up until the end of 2009, a conversion was not permitted if the taxpayer’s modified adjusted gross income (generally his income before the Roth conversion itself is considered) exceeded $100,000 (this applied to both single and joint filers). Thus, many middle- and upper-income taxpayers could not take advantage of a conversion. Starting in 2010, this restriction is permanently removed. On or after January 1, 2010, all taxpayers may convert any amount of traditional IRA accounts to Roth, as long as they are willing to pay the tax on the conversion. As a result of this change, higher-income taxpayers may also bypass the income limit for annual contributions to Roth IRAs (discussed earlier) by contributing to a traditional IRA and immediately converting it into a Roth IRA.  This achieves the same result as an annual contribution, but may be done at any income level.

The law change also provides that for 2010 conversions only, the resulting income is taxable half in 2011 and half in 2012, not all in 2010 as under the normal conversion rules. A taxpayer may, however, choose to pay tax on the conversion in 2010. This may be desirable if he has excess deductions in 2010, or if he expects to be in a much higher tax bracket (or expects Congress to increase tax rates significantly) in 2011 and/or 2012.

Traditional IRA contributions are not always deductible. Taxpayers who participate (or whose spouses participate) in employer-sponsored pension plans cannot deduct IRA contributions if their income exceeds certain limits. Such taxpayers may still contribute to traditional IRAs; however, they will not get a tax deduction for this contribution. Such after-tax contributions create "basis" in the IRA – since no deduction was taken at the time of contribution, no tax is due when the amounts are later distributed. Taxpayers that have made non-deductible contributions to a traditional IRA keep track of their basis on Form 8606 in their annual income tax returns.

Unlike a Roth IRA, earnings in a nondeductible traditional IRA are taxable upon distribution. A taxpayer with a non-deductible IRA may also own a separate IRA funded with deductible contributions, fully taxable when distributed. When taking traditional IRA distributions, a taxpayer cannot choose to withdraw her non-taxable basis first – any distribution is considered to come proportionately from taxable and non-taxable funds in all traditional IRA accounts. Only the original non-deductible contributions are tax-free. For example, assume a taxpayer owns two traditional IRA accounts.  One is $60,000 IRA that was funded with only pre-tax (deductible) contributions.  The other is a $40,000 nondeductible IRA which contains $30,000 of after-tax contributions (basis) and $10,000 of earnings.  Her total IRA balance is $100,000, in which she has basis of $30,000. Thirty percent of any distribution from either (or any combination of) these IRAs is nontaxable and 70% is taxable.  It does not matter which IRA provides the funds.

When a taxpayer owns a nondeductible traditional IRA, the same pro-rata rules that apply to distributions also apply to conversions. If the taxpayer in the above example were to convert any part of either traditional IRA to a Roth IRA, 70% of the conversion would be taxable and 30% would be nontaxable.

There is a method that can be used in certain circumstances to convert (or distribute) only the non-taxable portion. Since 2002, qualified pension plans may accept rollover contributions from IRA accounts, if the plan’s terms permit it.  If a taxpayer belongs to a qualified pension plan, and that plan accepts IRA rollovers, a special rule treats the rollover as coming first from taxable funds (in fact it is impermissible to roll nontaxable amounts into a qualified plan).  Thus you can "siphon off" some or all of the taxable portion to a qualified plan and then convert (or distribute) only the remaining portion, which will be nontaxable either in full or to a larger degree.

If the taxpayer in the above example belonged to such a plan, and rolled over the $60,000 taxable IRA to her plan, she could then convert the $40,000 IRA and pay tax on only $10,000.  If she also rolled $10,000 of the $40,000 IRA into her plan, the remaining $30,000 would consist of entirely non-taxable funds (basis) and could be converted to Roth (or distributed) with no tax consequences.

Many tax and financial considerations come into play when determining whether to convert your traditional IRA to a Roth IRA. If you have any questions about these conversions and the new 2010 planning opportunity, please contact our office.