Starting in 2010, all taxpayers, regardless of the amount
of their adjusted gross income (AGI), can convert a traditional individual
retirement account (IRA) to a Roth IRA.
Before 2010, your AGI cannot exceed $100,000 to convert, not including
any income resulting from the conversion.
Amounts converted must be included in income if taxable when withdrawn
(i.e., contributions and earnings in deductible IRAs and earnings in nondeductible
IRAs), but are exempt from the 10% early withdrawal penalty.
If you make a
conversion in 2010, the tax can be paid in two installments in 2011 and 2012,
with no tax due in 2010. However, if you
prefer, you can elect to pay the tax in 2010, which may make sense if the
current lower tax rates are not extended beyond 2010, or you expect much higher
income in 2011 and 2012. Taxes on
conversions made after 2010 must be paid in the year of conversion.
Even though
this tax rule does not go into effect until 2010, you should start planning
now. For instance, you should consider
making the maximum IRA contributions to a nondeductible IRA for 2007, 2008, and
2009, and then convert the nondeductible IRA to a Roth IRA in 2010. The maximum IRA contribution is $4,000 for
2007 and $5,000 after that, plus an additional $1,000 catch-up contribution for
taxpayers age 50 and older. After 2008,
the contribution amount will be adjusted for inflation in $500 increments.
By using this
strategy, you would only have to pay income taxes on earnings within the IRA
because the contributions are nondeductible.
However, be aware that if you also have other traditional deductible IRA
funds, even in another IRA account, you cannot just convert the nondeductible
IRA. You have to assume that a pro-rata
portion of both the deductible and nondeductible IRA funds are being converted.
Find out
whether your 401(k) plan accepts rollovers from an IRA. If it does, you could roll over your
deductible IRA and earnings in your nondeductible IRA to your 401(k) plan. You would then just have nondeductible
contributions remaining in your IRA, which could be rolled over to a Roth IRA
without paying any income taxes. Check
with your plan to see if you can later roll the funds back to an IRA.
This new
conversion provision will effectively remove the income limitations for
contributions to a Roth IRA after 2010.
For 2007, Roth IRA contributions can be made by single taxpayers with
AGI less than $99,000 (contributions are phased out with AGI between $99,000
and $114,000) and by married couples filing jointly with AGI less than $156,000
(contributions are phased out with AGI between $156,000 and $166,000). For 2008, Roth IRA contributions can be made
by single taxpayers with AGI less than $101,000 (contributions are phased out
with AGI between $101,000 and $116,000) and by married couples filing jointly
with AGI less than $159,000 (contributions are phased out with AGI between
$159,000 and $169,000). It doesn’t
matter whether you participate in a company-sponsored pension plan. Starting in 2010, individuals with incomes
over the limit can make contributions to a nondeductible traditional IRA and
then immediately convert the balance to a Roth IRA.
There are a
variety of factors that should be considered before deciding whether to convert
a traditional IRA to a Roth IRA. Factors
that favor converting to a Roth IRA include:
• You can pay
the income taxes due from the conversion with funds outside the IRA. By doing so, you are in essence increasing
your IRA’s value by the tax amount.
• You expect
your marginal tax rate at withdrawal to be equal to or greater than your
current marginal tax rate. When your
rates are equal at both times, the financial results from either IRA will be
similar. Increasing income tax brackets
generally makes it advantageous to convert to a Roth IRA.
• You won’t make
withdrawals from your Roth IRA for many years.
Estimates indicate that you generally need five to 10 years of tax-free
compounding to compensate for the current payment of taxes.
• You don’t
expect to take withdrawals from your IRA.
Since you aren’t required to withdraw funds from a Roth IRA, even after
age 70 1/2, your IRA balance can continue to grow on a tax-free basis.
• You want to
leave your IRA balance to heirs. With a
Roth IRA, your heirs receive the proceeds free of federal income taxes. Also, if you don’t withdraw funds from the
Roth IRA after age 70 1/2, you could potentially leave your heirs with a much
larger balance than from a traditional IRA.
Once the
balance is converted, a qualified distribution cannot be made until after the
five-tax-year holding period.
Distributions before then are subject to the 10% early withdrawal
penalty, unless one of the exceptions applies.
Make sure that
you are prepared to take advantage of the new Roth conversion rules in
2010. Please call if you’d like to
discuss Roth IRA conversions in more detail.
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