For tax year 2010, the IRS income ceiling for Roth IRA conversions disappears. The Roth IRA may be one of the most powerful retirement and estate planning tool which hasn’t been available to investors until now. This has presented an interesting quandary for many investors.
There has been plenty of information about this unique opportunity provided by financial advisors, tax professionals and others. Even with this wealth of information, the decision to convert your retirement assets to a Roth IRA is not an easy one. There are several factors to consider in determining whether or not a Roth conversion makes senses. Anyone suggesting everyone should do a Roth conversion is just plain wrong!
For some people, a Roth conversion makes sense. The best candidates for conversions are those who have a favorable tax attributes that can offset a majority of Roth conversion income. Business owners and others with net operating losses (NOLs) or those with charitable deduction carryforwards will find the conversion appealing. These losses and deductions may be used to lower or eliminate the tax liability created by the conversion.
Other good candidates for a Roth conversion are those who can pay the tax on the conversion from non-retirement funds and fit one of the following criteria:
· Those who don’t expect a significant decline in their tax rates at retirement;
· Those who have made a significant amount of non-deductible traditional IRA contributions over the years;
· Those who are making the conversion at a younger age;
· Those who don’t expect to spend down their IRA funds to meet living expenses at retirement;
· Those who intend to transfer all or a significant portion of their IRA at death to their beneficiaries.
While the criterion above suggests who may be good candidates for a Roth conversion, it still does not make the decision to convert an automatic one. There needs to be thoughtful analysis before making this decision. One of the major flaws with analysis provided by many advisors is the failure to consider the difference in tax rates before and after retirement.
Many analysis suggest a retirees tax rates will be equal to or greater than their tax rates prior to retirement. It is very interesting as the conventional wisdom prior to the Roth conversion opportunity was people would be at a lower tax rate during retirement. Even if tax rates do rise, most investment allocations for retirees tend to more tax advantaged vehicles.
Tax planning is a critical element of decision making process for implementing a Roth conversion. There are two options for paying the tax. The first is including all of the Roth conversion income on your 2010 tax return and paying all of the tax at 2010 tax rates. The second option is to defer the tax until your 2011 and 2012 tax returns paying tax on 50% of the conversion income in each year. The risk in deferring the tax is the likely increase in tax rates after 2010.
With the two choices to pay the tax on the conversion, a three year tax planning analysis is an absolute must. Retirees have to pay particular attention to how the conversion may impact the taxability of their Social Security benefits. They also need to be aware of how the conversion may affect their Medicare Part B premiums.
One nice feature allowed of a 2010 Roth conversion is the “money-back guarantee”. If a taxpayer is unhappy with the conversion for any reason he or she may re-characterize the Roth back into a traditional IRA by October 15, 2011. They will also have the option to re-convert it back into a Roth in the following tax year. This feature may come in handy if the value of the IRA drops significantly and the re-conversion can be done at a lower tax cost. Re-converting the IRA is not required. The only downsides are the need to amend prior tax returns to get a refund of the tax paid from 2010 conversion and the lost investment opportunity from not having use of those funds.
While the above provides a basic framework for deciding to convert a traditional IRA to a Roth IRA, it is highly recommended that you meet with your tax advisor to discuss a customized analysis based on your unique issues. No matter what advice you getting, the decision for implementing a Roth conversion is not a one size fits all.
Tags: Dolins, Dolins & Sorinsky, Roth Conversions, Roth IRA, The Tax Dude