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Saturday, January 29, 2011

To convert or not to convert: Special circumstances for taxation of Roth IRAs may make conversion a good idea (for some) (published in the Santa Barbara News Press in December of 2009)

With the recent “Great Recession,” we have seen many individuals losing their jobs in and around Santa Barbara.  Our most recent data from November 2009 shows 19,900 people unemployed in the county, which represents an 8.9 percent unemployment rate.  While we are still doing better than the state of California at 12.3 percent unemployment and the nation at 10 percent, having this large number of people unemployed is certainly placing a strain on our economy and our citizens. 
Many of us have worked for more than one employer, and have accumulated several IRA accounts over the years.  Whether we have a traditional IRA, an IRA rollover, an existing Roth, and/or employer retirement accounts, such as 401(k)’s or pension/profit-sharing accounts, there are numerous decisions that must be made concerning how best to manage these assets. 
Among the many issues that a recently unemployed person will face is the decision about what to do with their 401(k) or other retirement assets with their previous employer.  Also, for anyone with traditional IRAs or IRA Rollovers, the option of converting to a Roth IRA may offer some compelling benefits. 
Beginning in 2010, more people should be able to convert a traditional IRA to a Roth IRA, and take advantage of potential tax benefits. Prior to 2010, conversion was only available for those making $100,000 or less (adjusted gross income), whether single or married.  (If you earned $110,000 or more ($160,000 for married joint filers) then you also were not eligible to contribute to a Roth IRA.) 
The key benefit of converting to a Roth is that, although you will pay taxes on the pretax assets you convert, your money will grow tax-deferred in the Roth IRA, and withdrawals will be tax-free as well, when you have met certain requirements. New 2010 conversion rules may make converting to a Roth IRA more attractive, depending on your circumstances.
The $100,000 income limit that currently exists for Roth IRA conversions will be repealed for 2010 and future years.  Also, the income from a conversion in 2010 can be reported either on your 2010 tax return, or you can split it between your 2011 and 2012 tax years, meaning you would not have to make the first payment until April 15, 2012. 

One thing to keep in mind is that, if you have a non-deductible IRA, meaning that you contributed after-tax money to an IRA, you cannot just convert your non-deductible IRA balance (or part of it) and avoid the taxes you would have incurred, had you converted the deductible IRA (or part of it).  The federal government uses a pro-rata system of calculating taxes due.  Here is an example:

Let’s say you have $50,000 in a traditional (deductible) IRA, and another $50,000 in a non-deductible IRA (a total of $100,000).  If you wanted to convert $20,000 of your IRA assets to a Roth, you would owe taxes on $10,000, since the amount in your non-deductible IRA represents 50 percent of the total.  This 50 percent is $10,000 of the $20,000 you wish to covert, leaving the remaining $10,000 that comes from your regular IRA, and which is taxable upon conversion. 

One of the potential benefits of converting soon is that most IRAs and qualified plans hold assets with depressed values. The current value will be taxed at conversion (assuming we are talking about deductible money in a traditional IRA) and the future growth will be tax-free (if qualifications are met).  Another benefit, and a key reason to convert, would be if you have a long time remaining before you will access your retirement assets, leaving a lot of time for the converted assets to grow tax-free.  I would want to have at minimum five years for assets in the Roth to grow to make the conversion make sense.

Roth conversions can be recharacterized, and you have until October 15 of the year following the year you converted to recharacterize back to a traditional IRA for any reason. However, if you do recharacterize your 2010 Roth conversion, a reconversion will not be allowed until the following year, and you will no longer be able to spread income tax from the conversion over two years.

If you hold after-tax money in a 401(k) plan, you can request a direct rollover of pretax contributions and earnings to a traditional IRA and convert after-tax assets and earnings directly to a Roth IRA. This allows you to fund a Roth IRA conversion and pay income taxes only on earnings from after-tax contributions.

Roth IRA conversions can reduce the size of your taxable estate because of the income tax already paid and can allow you to pass income on to beneficiaries income tax-free. (The Roth assets may still be subject to estate tax though.)

Roth IRA conversions can be a great opportunity but they are not for everyone. Before you convert to a Roth IRA, consider the following:

·         Your tax bracket - Because you pay taxes when you convert pre-tax contributions and earnings to a Roth IRA, doing so would be most advantageous if your tax bracket is lower now than it will be when you withdraw the assets.  With this said, if you have a long time between now and when you will need to withdraw funds from the Roth, the tax bracket differential is less important. 
·         Your time frame - You need a significant amount of time to accumulate the earnings that will be distributed from the Roth tax-free. A minimum of five years is needed, but a longer time frame is usually advisable. A Roth IRA conversion can be especially effective when the money is passed on to your heirs.
·         Your ability to pay conversion taxes with non-IRA assets - Paying taxes with non-IRA assets makes Roth conversions more advantageous. If you pay the taxes from the assets in your traditional IRA, you reduce the amount that will be able to grow tax-free in the Roth IRA. In addition, while assets you convert are not subject to penalty, any amount you withhold to pay for the conversion taxes is. In other words, if you pay taxes due on conversion with your IRA assets, that amount is treated as a distribution and is subject to income tax and a 10 percent IRS penalty if you are under age 59½.  Therefore, you either need to have the additional cash available, either for April 15, 2011, (or, if you spread the tax burden over the 2011 and 2012 allowed years, you will need half of the taxes due for each tax year), or you will be forced to pull money out of the IRA assets and pay the 10 percent penalty in addition to the taxes.

This is the time to look carefully at converting in 2010.  For many local residents who have accumulated large IRA balances, the early withdrawal penalty may make a Roth conversion unattractive.  If you have very large IRA balances, and will not have the additional cash to cover the tax burden, even if you spread the taxes over the 2011 and 2012 tax years, it probably does not make sense to convert to a Roth.  Also, if you do not have at least five years to leave the funds invested before you need to make withdrawals, I would not recommend converting.  However, if you have the time, and you can afford to pay the taxes, I would highly recommend taking advantage of the conversion and the two-year tax payment option, because the ability for your assets to grow tax-free, especially from current levels, could make a huge difference down the road.  As with any significant financial decision, one should always consult their financial advisor or tax expert before deciding whether to convert to a Roth IRA.

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