The New Roth IRA Conversion

By: M. David Gracy Jr., CFP®
Contributing Writer to The Village Journal at Haile Plantation

New tax laws have taken effect this year allowing for what The Wall Street Journal  (Greene, Kelly. 12/12/2009) called “one of the biggest changes on the IRA landscape in years.” In 2010, the over 20 million investors in America with a modified adjusted gross income (MAGI) of more than $100,000 are able to convert a traditional IRA to a Roth IRA.  Until this year, the IRS prevented single and joint filers from performing such a conversion if their MAGI was over $100,000.  Thanks to an element of the Tax Increase Prevention and Reconciliation Act of 2005, that earnings limit has been repealed.

Roth IRAs have long been considered a valuable retirement planning tool particularly for the following two reasons:  tax-free growth of earnings and tax-free income distributions in retirement (provided the account owner is at least 59 ½ and has held the Roth for 5 years or more).  Additionally, careful estate planning could facilitate decades of tax-free growth for your Roth IRA assets.

As opposed to a traditional IRA, a Roth is not subject to required minimum distributions (RMDs) during the owner’s lifetime.  Your spouse, if named beneficiary of your Roth IRA, may treat the inherited IRA as his or her own upon your death and thereby forego withdrawals.  This tactic allows the Roth assets to continue compounding untaxed across the rest of your spouse’s life.  Let’s take it a step further, to the next generation, and assume your spouse has named a son or daughter as beneficiary.  That heir then has the ability to make tax-free minimum withdrawals according to his or her life expectancy as the Roth assets continue to compound tax-free

Please be advised that upon performing a Roth IRA conversion, you would incur a taxable event.  The IRS regards a traditional IRA to Roth IRA conversion as a distribution from a traditional IRA.  You would be faced with a tax bill with respect to the conversion.

In an apparent effort to help ease the tax pain, Congress has approved a special rule that applies to conversions completed in 2010 only.  You may choose to delay the tax liability and pay half the taxes on the conversion with your 2011 tax return and half with your 2012 return.  However, be aware that federal income tax rates very well may be higher in the future than they are currently.  This consideration suggests 2010 may be a good time to convert, and pay the taxes due with your 2010 tax return.  Also, remember that although the income limit on Roth conversions has been repealed, the income limit on Roth IRA contributions still applies.  Therefore, high-income IRA owners can make the conversion, but may not be able to contribute new funds to the account.

Determining the applicable conversion rules and tax calculations can be a complicated task.  There are many variables to be considered and, of course, these variables may differ greatly from family to family or person to person.  Since a mistake could result in unforeseen taxes and penalties, be sure to consult your CPA and financial advisor regarding conversion options and their suitability to your particular situation.

David is a certified financial planner™ practitioner and independent financial advisor at M. David Gracy Jr., CFP®, LLC - located in the Springhill Professional Center in northwest Gainesville (352.336.3039) and on the web at DavidGracy.com.