Traditional to Roth Conversions – The Pros & Cons
By Michael P Carroll, CLU, ChFC, CFP® – American National Bank
According to the Taxpayer Relief Act of 1997, there is a special traditional IRA to Roth IRA conversion privilege. The following is a brief discussion of some important points.
First let’s review traditional IRA and Roth IRA rules. Maximum contribution limits to a traditional IRA in 2009 is the lesser of either the taxpayer’s income or $5,000. For those who attained the age 50 on or before December 31, 2008 there is a $1,000 make up provision. This would allow someone 50 or older as of that date to contribute $6,000 to their IRA. There are limitations to deductibility however. One is whether or not the taxpayer and/or spouse are active participants in a qualified plan and the other is based upon Adjustable Gross Income.
There is no deductibility restriction if neither the taxpayer nor the taxpayer’s spouse is an active participant in a qualified plan. If either spouse is an active participant, then the following AGI restrictions apply: the deductibility of IRA contributions is phased out on a pro-rata basis for a single taxpayer if their AGI is $55,000 to $65,000. Joint filers phase-out levels are $89,000 to $109,000, unless one spouse is not active, then the phase out range is from $166,000 to $176,000 for that spouse. AGI is calculated by using the original AGI and adding back the IRA deduction and deducting savings bond income for higher education and adoption assistance, interest paid on qualified education loans and several other more esoteric deductions. Please check with your tax professional.
The Roth IRA contribution restrictions are slightly different. The maximum eligible contribution for a Roth IRA is phased out as modified AGI increases from $105,000 to $120,000 for single filers and $166,000 to $176,000 for joint for 2009.
The conversion provision in the 1997 Act involves only those amounts converted from a Traditional IRA to a Roth in 2010. The Act allows a taxpayer to report these conversions equally over 2011 and 2012 instead of reporting them all in 2010. An example would be if a taxpayer converted $100,000 from his/her traditional IRA to a Roth in 2010 the income would be reported as $50,000 in 2011 and $50,000 in 2012. Tax payers may always choose to elect out of this treatment.
Normally, in order to be eligible for a Roth conversion, the modified AGI of the taxpayer must be less than $100,000 for both single and joint filers. However, the 1997 act removed these limits for 2010.
There are a couple of caveats, however, that one should be aware of when considering a Roth conversion. Roth’s have something called a 5-year rule, which means that you cannot withdraw money from a Roth, without penalty, until five years after its establishment. This also applies to a Roth conversion. Distributions from Roth IRA’s must also be qualified distributions in order to avoid the penalty tax. Qualified distributions must meet four tests or they potentially become taxable. In most cases, non-qualified distributions are subject to ordinary income tax and a 10% excise tax that is not deductible.
Roth conversions fall under the same five year holding period. At one time it was suggested that an individual anticipating a conversion set up a Roth early just to satisfy the holding period. However, conversions have their own holding period even though the Roth itself is over five years old.
There are several additional considerations in converting to a Roth. One is an individual’s opinion on the future of tax rates. Another is how soon the IRA holder is going to need access to the money, and the last is whether or not the IRA owner has the money to pay the taxes on the conversion. Taxes cannot be paid out of the Roth because that would violate the 5-year rule.
There is a remedy if someone makes an error in converting their Roth. The taxpayer may be able to re-characterize the conversion, which would in essence negate the original conversion. As you can see this can be a complex process. Anyone entertaining the idea of a Roth conversion should contact a tax professional or a qualified financial planner who can model this conversion with varying assumptions.