Michelle Addison, Bingham McCuthchen LLP
Enacted in 2006, the Tax Increase Prevention and Reconciliation Act eliminates the existing $100,000 modified adjusted growth income cap for converting a traditional individual retirement account (IRA) to a Roth IRA starting on January 1, 2010. While the conversion from a traditional IRA to a Roth IRA is treated as a taxable distribution, the taxpayer may choose to pay income tax on the entire converted amount in 2010 or have one-half of the taxable converted amount taxed in 2011 and the other half in 2012. The client also has the option of converting in installments over a number of years to take less of a one-time tax hit, instead of converting the entire IRA in 2010.
The major benefit of converting to a Roth IRA is that earnings and withdrawals are income tax-free so long as the individual (i) has held the Roth IRA for a minimum of five years from the date of conversion and (ii) is at least age 59½ at the time of withdrawal. Roth IRAs also have no required minimum distributions after age 70½. In addition, by paying the income tax on the IRA upon conversion, the client’s taxable estate would be reduced by the amount of income tax paid—in Massachusetts, this should be advantageous even after taking into account the IRD deduction allowed traditional IRAs under Section 691.
All other things being equal, in deciding whether to convert to a Roth IRA, a primary consideration is the client’s marginal income tax bracket—both the current rate and estimated future rate. If the client’s predicted future tax bracket is lower than his or her current marginal rate, conversion might be less attractive than it would be if tax rates or the client’s income were predicted to increase. If the client’s current and future marginal income tax brackets are the same, then a converted Roth IRA should produce the same amount of wealth as a traditional IRA after the payment of income taxes. Of course, all situations are unique and clients should consult legal counsel and/or financial advisors to determine if conversion is advisable for them.
Another concern is whether the client will be able to pay the taxes resulting from the conversion without dipping into the IRA’s assets. Conversion may not make sense for a client if he or she cannot pay the taxes from an independent source of funds. If a client converts a traditional IRA to a Roth IRA but reserves a portion of the IRA funds to pay the tax, the 10% early withdrawal penalty will also apply if the client is under age 59½. Therefore, for younger clients unable to pay the income tax from non-IRA assets, a Roth conversion may not be efficient.
The recent market decline, which has resulted in lower value of many IRAs, makes conversion attractive as the tax cost is reduced. Conversion will also protect the IRA from any future tax increases. After careful analysis of each client’s estate and income tax planning considerations, 2010 may be a good year to convert for many.