ROTH IRA Conversions – Critical Decisions To Be Made In 2010

To Convert Or Not To Convert?

Beginning in 2010, all taxpayers, regardless of their income, are eligible to convert traditional retirement savings to Roth IRAs. This new opportunity has left many of our clients wondering whether now is a good time to convert their IRA or retirement plan accounts. To the extent that retirement savings are in a qualified retirement plan, the participant must be eligible to take a distribution, pursuant to the terms of the plan, and roll it to an IRA, in order to convert. This Client Advisory will explain the differences between regular and Roth IRAs, as well as some factors clients should consider when deciding whether to take the plunge.

In a traditional qualified plan or IRA, contributions generally are made on a pre-tax basis, and earnings accumulate on a tax-deferred basis. Taxes are paid on the contributions and earnings only upon distribution. Minimum distributions from a traditional IRA must begin in the year following the year the IRA owner attains age 70-1/2.

In a Roth IRA, on the other hand, contributions are taxed at the time they are contributed, earnings accumulate on a tax-free basis, and distributions are tax-free if they are "qualified distributions." A "qualified distribution" from a Roth IRA means a distribution that is made after the five-year period beginning with the first tax year in which the taxpayer made a contribution to a Roth IRA. A qualified distribution is made for one of the following reasons: (i) after the account holder attains the age of 59-1/2; (ii) after the account holder's death; (iii) after the account holder becomes disabled; or (iv) (in limited circumstances) to purchase a new home as a qualified first-time homebuyer. Distributions that are not qualified distributions are generally subject to a 10% premature distribution penalty and income tax on the earnings of the IRA. Unlike traditional IRAs, Roth IRAs are exempt from the lifetime rules regarding required minimum distributions (however, after the account holder's death, the beneficiary of the Roth IRA must begin to take the required distributions).

Traditionally, retirement experts have advocated for the deferral of taxation if at all possible. Experts have been concerned about any tax benefit promised 10-20 years later, especially when the taxpayer has to pay taxes now rather than continuing to defer. In addition, Congress possibly could eliminate or change the Roth IRA option in the future.

If you are thinking about converting, you should consider the following questions:

Do you need the money that you would convert, or can it remain in the IRA until the later of five years or age 59-1/2? A taxpayer who has a number of years until retirement, or who is planning on passing on the Roth IRA account to his or her heirs, will be a better candidate for conversion, since that taxpayer hopefully will have more time to accrue earnings that will be distributed tax-free.
Do you anticipate that your tax bracket will be higher or lower in the future than it is right now? If you think that your tax rate will only increase in future years, the benefit of paying the taxes now, instead of later during a Roth conversion, may be an important consideration.
Can you pay the tax on the conversion from nonretirement account assets? If you can pay for the taxes outside of the Roth IRA, you will be able to take better advantage of the opportunity to build up more tax-free earnings on the assets in the Roth IRA.

Special Rule Allowing Division of Taxes

Taxpayers considering a conversion in 2010 also will need to determine whether to pay the taxes on the conversion for that year, or whether to spread the taxes on the conversion equally over 2011 and 2012. This special rule will not apply for conversions beginning in 2011. An important consideration in the decision to defer the tax will be whether Congress allows the scheduled tax increases to go into effect in 2011.

Free Look Opportunity

Taxpayers should consider strongly making a Roth conversion in 2010, because taxpayers will have until October 15, 2011, to decide whether to keep the Roth or elect to treat it as a non-Roth. So, everyone gets a free look to determine if the Roth should be kept and will be able to see whether tax rates will increase in 2011 before committing to the conversion.

For example, if a taxpayer elects a Roth conversion in November, 2010, and the account appreciates by 10% next year and tax rates increase, the taxpayer may want to retain the Roth. If the account depreciates, then the taxpayer may not want to retain the Roth treatment. If tax rates do not increase, the taxpayer may want to take advantage of paying the taxes in 2011 and 2012 rather than paying the entire tax amount for 2010.

If a taxpayer converts to a Roth, and the account subsequently declines materially in value later this year, the law permits the account to be recharacterized as a non-Roth and then reconverted under special rules at the lower value next year.

A Final Thought

Taxpayers may want to consider a conversion of only a piece of their retirement accounts, rather than thinking of conversion as an all-or-nothing decision, and may want to consider separate Roth accounts for different investments. By using Roth conversions as a way to diversify investments, taxpayers will have greater flexibility in making decisions regarding taxation and potential reconversions.

If you have any questions about this Client Advisory, please contact any member of our Employee Benefits Team.

Sherman & Howard has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation. This does not create an attorney-client relationship between any reader and the firm. If you want legal advice on a specific situation, you must speak with one of our lawyers and reach an express agreement for legal representation.

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