New Rules for Roth IRAs May Prompt Conversions

Prior to 2010, your adjusted gross income (AGI) had to be less than $100,000 to convert an individual retirement account (IRA) or qualified plan to a Roth IRA. Beginning in 2010, there are no AGI limitations, making many more taxpayers eligible to convert their accounts. In addition, the taxable income recognized on the amount converted in 2010 may be spread over the next two years. So, is a Roth conversion right for you?

Roth IRA conversion planning can be complicated, so carefully consider the effects on your financial goals and objectives.

A Roth IRA has several advantages over traditional IRAs and qualified plans:

• Tax-exempt growth
• Tax-free distributions (in most cases)
• No required minimum distributions (RMDs)

When contemplating a conversion, you have to consider your overall retirement and estate planning goals, the current tax cost to convert an account, state tax laws, and future tax savings. The amount converted to a Roth IRA is included in your taxable income (less any previous non-deductible contributions to the account).

Here are several situations that may justify a Roth conversion:

• You have a current year ordinary loss or loss carryover, such as a prior credit carryover, net operating loss carryover, or charitable contribution carryover.
• You have cash available from non-retirement accounts to pay the additional tax.
• Your estate planning goals include leaving tax-free assets to your heirs.
• You are looking for a way to reduce your annual RMDs.
• Your financial plan includes adding more assets to your “tax-free” bucket and less to your “tax-deferred” and “taxable” buckets.
• You believe future income tax rates in withdrawal years will be the same or higher than in the conversion year.
• You have a long-time horizon to take advantage of tax-free growth, and you do not anticipate needing to draw on the Roth IRA for at least 10 years.
• The amount converted is taxed at your current marginal tax rate or less (i.e., the amount converted does not push you into a higher tax bracket).
• You have a taxable estate and could benefit from reducing the size of your estate by the amount of income taxes paid on the conversion.

When considering this decision, remember that a Roth conversion may be “undone” anytime before your tax return filing due date. For example, if you convert an IRA to a Roth IRA in January 2010, you have until April 15, 2011 to “undo” it; if you file for an extension, you have until October 15, 2011. This gives you and your financial advisor 18 months to decide if the change meets your tax, estate, and retirement planning objectives.

A few more points to consider when determining if a Roth conversion is right for you:

• Although a Roth IRA is not subject to RMDs, an inherited Roth IRA is subject to RMDs. However, both enjoy tax-free growth.
• An inherited traditional IRA can not be converted to a Roth by your non-spouse heirs; however, an inherited qualified plan (i.e., 401(k)) may be converted to a Roth by your heirs.
• Federal bankruptcy laws provide unlimited protection for qualified plans; however, IRAs have a limit of $1 million. Therefore, you may not want to rollover or commingle a qualified plan with an IRA if your balances exceed or are projected to exceed $1 million.
• Asset protection outside of bankruptcy is available for qualified plans, whereas it may not be available for IRAs. For example, a retired professional with a 401(k) may not wish to rollover his/her plan to an IRA or Roth IRA if there is a chance of being sued for residual liability. The potential income tax benefits from a Roth conversion may not outweigh the asset protection risks.
• Some states may not have adopted the federal ROTH IRA conversion rules discussed above. A tax advisor will know the rules that pertain to your state.

Roth IRA conversion planning can be complicated. If you have a qualified plan or IRA, consider the effects of a conversion on your financial goals and objectives. A professional financial advisor can help you determine if it’s right for you, your family, and your heirs.

Donna Murr is a Certified Financial Planner™ and senior wealth advisor with LarsonAllen, Financial, LLC, member FINRA & SIPC with more than 24 years experience in comprehensive financial planning and individual income tax services.
Contact Donna at dmurr@larsonallen.com or 715-852-1146.

The information in this article should not be taken as advice, as each person’s situation is different. Tax laws are subject to change. Please consult with a professional regarding your specific circumstances. Investments entail risk, including potential loss of principal. Past performance is no guarantee of future results. This material may not be republished in any format without prior consent.