Changing the Game: A Look at the New Roth IRA Conversion Rules - Part 1

Tom Magnor, CPA, Tax Senior   email
December 2009

While the phrase, “this is the opportunity of a lifetime,” is a bit cliché, the upcoming changes to the Roth IRA conversion may be just an opportunity of a lifetime. Beginning January 1, 2010, the Roth IRA adjusted gross income (AGI) limitation for conversions will be removed and provide a significant tax planning opportunity for many taxpayers. The tax rules in 2010 will allow IRA owners, regardless of their income levels, to convert some or all of their traditional IRAs into Roth IRAs. This change can provide taxpayers with income tax savings and perhaps some flexibility when planning their estates. This article is the first in a two-part series and will cover some background on IRAs and what changes lay ahead in 2010 for Roth IRA conversions.

Back to the Basics

An Individual Retirement Account (IRA) is an investment vehicle for individuals to save for retirement. The IRA was created more than thirty years ago and now has two distinct types: the traditional IRA and the Roth IRA. Each has its own tax advantages, disadvantages and limitations.

The appeal for the traditional IRA is that there are fewer restrictions on how much an individual can contribute to the account. The general limitation for an annual IRA contribution is $5,000 per year, but it can be increased to $6,000 for individuals age 50 and over. Contributions made to a traditional IRA can be tax deductible, the earnings grow on a tax deferred basis, and the distributions from the IRA are taxable. Individuals are generally not allowed to begin taking distributions until age 59½ and cannot permanently keep funds in an IRA. IRA owners must make Required Minimum Distributions (RMD) by April 1 after they reach age 70½. This provision prevents taxpayers from indefinitely deferring income taxes related to their IRA.

A Roth IRA also provides tax savings for retirement but in a different structure from the traditional IRA. With a Roth IRA there is no upfront deduction for contributions, but unlike a traditional IRA, no tax is owed upon distribution. As with a traditional IRA, the earnings grow tax-free within the Roth IRA. Further, there are no RMD rules once the individual reaches age 70½. Without any RMD provisions, the use of Roth IRAs allows individuals to pass on their retirement wealth. While offering many tax benefits, tax law limits who may establish a Roth IRA. Annual Roth IRA contributions are restricted to individuals with a modified adjusted gross income (AGI) of less than $176,000 in 2009 for a married couple filing jointly. In addition, taxpayers are permitted to convert from traditional IRAs to Roth IRAs only if their AGI is under $100,000. Taxpayers must pay income tax on the amount in their IRA account at the time of the conversion, but generally no income tax is owed after the conversion. The absence of the RMD and the advantage of tax-free distributions make the Roth IRA an attractive opportunity; however, the current AGI limitations prevent many taxpayers from being able to establish them.

The Opportunity

The key federal legislation changing Roth IRA conversions was enacted in 2006 but is not effective until 2010. This legislation eliminates the $100,000 AGI limitation on conversions to a Roth IRA. This allows taxpayers with an AGI greater than $100,000 (who were previously ineligible for a Roth IRA conversion) to convert traditional IRAs into Roth IRAs. The amount converted from a traditional IRA to a Roth IRA will need to be included in the taxpayer’s income. Please note that the taxpayer determines how much is converted; it can be any portion or all of the traditional IRA.

[Caution: While this article focuses primarily on the federal tax impact of the Roth IRA conversion, the state tax affect should also be considered, especially for Wisconsin residents. Wisconsin's tax laws at this time do not allow Roth IRA conversions in 2010 to receive the same federal treatment when the $100,000 AGI limitation is removed, and thus, Wisconsin’s rules could trigger tax penalties. The Wisconsin legislature may soon remedy this situation; until then, Wisconsin taxpayers may want to consider postponing a Roth IRA conversion.]

Taxpayers who convert to a Roth IRA in 2010 will be able to defer the recognition of income from the 2010 conversion by splitting the income in half and including these amounts as income in 2011 and 2012. This provides taxpayers more time to gather funds to pay the tax on the conversion. This two-year deferral is required for Roth IRA conversions in 2010; however, taxpayers may elect to be taxed on all of the conversion income in 2010.

If Congress is offering payment over two years, why would anyone want to pay the taxes in one year? As tax rates are expected to increase in 2011, taxpayers may realize tax savings by electing to accelerate all Roth IRA conversion income into 2010. Also, by electing to tax the conversion income in 2010, any applicable carryovers may be available to soften the impact of the 2010 tax. While this opportunity for recognizing the Roth conversion income in 2010 may be appealing to some, there are many considerations and calculations to be analyzed before filing a 2010 tax return.

The fact that all taxpayers are able to convert some or all of their traditional IRA into a Roth IRA starting in 2010, does not necessarily mean this should be done in every case. There are a whole host of factors and other assumptions that need to be analyzed, and each situation is different. The process of analyzing the factors to consider and performing the tax projections will be addressed in Part 2 of this topic in the January issue of The Adviser.