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January 2010 | dlpmagazine.comWeb Exclusive Is the Roth IRA conversion a gamble?Understanding the 2010 IRA-to-Roth IRA conversion opportunity.by J. Haden Werhan, C
January 2010 | dlpmagazine.com
Is the Roth IRA conversion
Understanding the 2010 IRA-to-Roth IRA conversion opportunity.
by J. Haden Werhan, CPA/PFS, of Capital Performance Advisors
Photo: Jupiterimages/ Getty images
It’s 2010, and it’s official. With the advent of the new year, we also face an intriguing new tax-planning option, one that offers us both opportunities and challenges, especially during 2010–2112. It’s the arrival of new IRA-to-Roth-IRA conversion rules. Now that they’re here, it’s worth taking a bit of time from the bench to consider what they mean to you, your wealth, and your retirement and estate planning needs.
Should you convert?
There are a variety of reasons you may decide to convert your traditional IRAs to Roth IRAs, which have two major advantages over traditional IRAs:
First, Roth IRA distributions are tax-free if they are qualified distributions. To be qualified, they must be made after a five-year holding period has passed and after the accountholder reaches age 59½.
Second, Roth IRAs are not subject to the required minimum distribution (RMD) rules that apply to traditional IRAs. Therefore, a Roth IRA accountholder who reaches age 70½ does not need to begin taking distributions; instead, the funds can continue to grow tax free until they are needed or are passed to heirs.
The tax-free nature of Roth IRA distributions may help you avoid higher tax brackets that would otherwise apply if you were withdrawing distributions from a traditional IRA. Moreover, these distributions-unlike those from traditional IRAs-do not affect the calculation of tax owed on Social Security payments.
You should consider an IRA-to-Roth-IRA conversion if any of the following apply to you:
How it works
Before you start immediately filling out the conversion paperwork, it’s important to assess a few essential details on how the conversion rules work and how they may impact you one way or the other.
First, it’s important to understand that an IRA conversion is treated as a taxable distribution. It’s taxed as ordinary income at your marginal tax rate (although it does not trigger any early withdrawal penalty, as an ordinary withdrawal would). This in effect accelerates the taxable income that you would eventually have had to pay on distributions from a traditional IRA when you retire. It does so in exchange for never taxing any future appreciation in the value of your account. This can be a significant tax advantage for some taxpayers …but it may or may not be an advantage for you.
Second, if you do choose to convert in 2010 and pay the taxes sooner than later, you face another decision on exactly how soon. Although conversion to a Roth IRA triggers immediate taxable income, Congress has provided a special incentive in 2010 to jump-start Roth conversions under the new rules: In 2010 (and 2010 only) you must elect one or the other of these two options: You can recognize all the conversion income in 2010. Or, you can average it over 2011 and 2012, spreading taxes on the converted amount over the rates in effect during those two years.
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Third, even if you can chart out your own expected income during the coming three years, several forces beyond our control take an already interesting tax-planning equation and create even greater challenges. For some taxpayers, their tax rate may rise after 2010 even if their income does not. This is because The Economic Growth and Recovery Act of 2001 expires and the top (maximum) tax bracket of 35% goes away with it. In its place, pre-2001 marginal income tax rates return in 2011, including the top two brackets of 36% and 39.6%.
It’s possible increases will be even higher than scheduled. How so? President Obama’s 2010 budget proposal makes permanent the 10%, 15%, 25% and 28% individual income tax brackets. This would be good for individuals with taxable income of less than $190,650 and for married couples filing jointly with taxable income less than $231,300. But in 2011, as mentioned above, the 33% and 35% rate brackets become 36% and 39.6%, respectively, which means you won’t need to earn as much to reach the 36% bracket. Will all of this actually happen? We don’t know, but stay tuned for developments as budget, health care reform and other initiatives work their way through Congress.
For now, you can at least think of it as an automatic tax increase of some sort or another, beginning in 2011. If you do not want to take the chance that your income tax rates will be higher in 2011–2012 than in 2010, you may elect to pay the full tax on the Roth conversion in 2010.
Clearly, deciding whether to convert from traditional to Roth requires some careful planning for tax years 2010–2012. This is especially so if your income is subject to fluctuation, as is the case among many dental professionals given the recent economic turmoil. It also requires assessing the optimal way to report a conversion taken, and calculating proper payment of estimated taxes thereon. And remember, the Roth conversion is not an all-or-nothing proposition. You may convert as little or as much of your traditional IRA as you want.
Applying it to you and yours
If you are planning to take advantage of the Roth IRA conversion opportunity, consider some of the following:
Seek professional assistance
Just as you might seek the advice of a specialist for a particularly complex treatment plan for a patient in your dental practice, the best advice on how to sort through the many possible benefits and considerations related to the new 2010 Roth Conversion rules is to contact a trusted advisor to discuss your personal situation. Some of this planning is straightforward, but as you drill down into each facet of how a Roth conversion can affect you long term, you are really looking at some very advanced planning.
J. Haden Werhan, CPA/PFS, is a partner at Capital Performance Advisors LLP in Walnut Creek, Calif. Haden specializes in advising dental professionals on tax and wealth management strategies. He can be reached at 800-877-0564.