|
Article Archives...
Converting a Traditional IRA into a Roth IRA
Roth IRAs are tax-favored accounts that allow after-tax contributions to grow and later be distributed without tax. The chief advantages of Roth IRAs over traditional IRAs are that the owner is not required to take distributions during the owner's lifetime, so the tax-free buildup can continue through the owner's life, and that qualified distributions (including distributions to beneficiaries after the owner's death), are completely tax free when made. In contrast, a traditional IRA is subject to the minimum distribution rules, so the owner must begin receiving distributions in the year following the year in which the owner turns 70 1/2 and take them over a prescribed period, and the distributions are fully taxable, except to the extent they represent the return of after-tax contributions. A taxpayer that has a traditional IRA can convert it to a Roth IRA to take advantage of these features, as long as the taxpayer’s adjusted gross income (not including any amount included as a result of the conversion) is less than $100,000 in the year of the conversion (and the taxpayer files a joint return, if married). [2] However, the conversion comes at a cost: the amount transferred to the Roth IRA is treated as a distribution and must be included in the taxpayer’s income in the year of the deemed distribution. [3] In other words, the tax-free receipt of earnings applies only to post-conversion earnings, since earnings accumulated before the conversion are taxed at the time of conversion. Beginning in 2010 the $100,000 limit is lifted. In addition, unless that taxpayer elects otherwise, the amount converted will be included ratably in taxable income over a two-year period beginning in 2011.[4
COST-BENEFIT ANALYSIS Although the determination as to whether a Roth conversion is the right move depends on the facts in each individual situation, there are some guidelines that can be followed in weighing the costs and benefits of a Roth conversion. the greatest benefits are available to those who will leave the money in the IRA (whether Roth or traditional) for the longest time (preferably until after death), as this maximizes both the length of time for which tax is deferred and the amount of post-conversion earnings that eventually escapes tax. Thus, for example, individuals who do not need the money contained in a traditional IRA should generally convert the IRA to a Roth IRA, as this will allow their beneficiaries to receive the amounts tax-free. On the other hand, if an individual needs or plans to make withdrawals from the IRA within a shorter period of time, such as five to ten years, it is best to continue with the traditional IRA because the short time horizon will not allow the individual to accrue enough post- conversion earnings to make up for the taxes paid on a conversion. The most important factor in terms of the cost is the IRA owner's tax bracket at the time of the conversion compared to the IRA owner's tax bracket at the time he expects to take distributions, since in making a conversion, an IRA owner is choosing between current taxation on the existing balance of the IRA if the conversion is made, and taxation at the time of distribution, if the IRA remains a traditional IRA. Thus, if an individual with a traditional IRA plans to take distributions from the IRA during retirement, and if the individual expects to be in a substantially lower tax bracket at that time, the individual should probably continue with the traditional IRA. For example, if an individual is currently in the 28 percent (or higher) tax bracket, and if the individual expects to be in the 15-percent tax bracket during retirement, a conversion does not make sense because the tax rate that will be imposed on the conversion amount will be higher than the tax rate that will be imposed on withdrawals made from the traditional IRA. However, the length of time and the expected rate of return on the IRA also enter into the equation, since the tax at the time of conversion will apply only to the balance at that time, while the tax on distribution if the IRA is not converted will apply to a much greater amount, including all earnings accrued after the time the conversion would have occurred.
ABILITY TO PAY TAX Even a taxpayer for whom the benefits outweigh the costs will not want to make an IRA conversion if the tax liability resulting from the conversion will be so large that the taxpayer cannot pay it. Thus, an important factor in making a conversion decision is whether a taxpayer has the necessary funds to pay the tax liability. And these funds must be held outside the IRA, since if the taxpayer must use cash from inside the IRA to pay the tax owed, the cash used to pay the tax will be treated as a withdrawal and will be subject to the 10 percent penalty tax if the taxpayer is not yet age 59 1/2. [5] In addition, there will be less funds working in the IRA for the taxpayer, so the benefit of the conversion will be lessened. A taxpayer who does not have the funds necessary to pay the tax liability but who can benefit from a conversion should consider converting part of the traditional IRA to a Roth IRA each year over a number of years. This technique has the effect of spreading out the taxpayer’s tax liability over a time period selected by the taxpayer. THE ANSWER MAY CHANGE Whether to convert an IRA to a Roth IRA is an issue that should be reconsidered over time, since the answer will not always be the same. A taxpayer who could not convert in one tax year because of adjusted gross income over $100,000 (before 2010) may have much lower adjusted gross income in another year, as a result of a personal event such as unemployment, a sabbatical, or a disaster or other loss, a change in marital status, or retirement (and if the taxpayer's adjusted gross income is close to $100,000, it may be possible to reduce it by using traditional strategies to delay income to the following year or the taxpayer may be able to wait and convert in 2010). A taxpayer who, at first, could not afford to pay the tax or for whom the cost outweighed the benefit may find that this situation has changed. For example, if there is a significant decline in the value of the assets in the taxpayer's traditional IRA, such as from a decline in the stock market in the case of IRAs invested in stocks or mutual funds, the tax cost of converting to a Roth IRA will then be lower. If the conversion occurs after 2009, the taxpayer may have the funds to pay the tax over a two-year period as prescribed under current law for post-2009 conversions. Finally, a taxpayer for whom the benefits outweighed the costs but who did not have the liquid assets to pay the tax may find that the liquid assets are later available.
|
|
|
