Schutte & Hilgendorf – Prescott Accountants

Starting in 2010, anyone with a traditional IRA can convert all or part of it to a Roth IRA.  Once you have had a Roth IRA for at least five years and after you are age 59 1/2, all withdrawals are tax free.

You will owe income tax on a Roth IRA conversion.  If you convert in 2010 you can elect to defer the tax payments to 2011 and 2012.  Even with this deferral, you probably will pay income tax much sooner that you would have paid if you had kept the money in a traditional IRA.

REASONS TO CONVERT

ESTATE PLANNING

• You are not required to take any withdrawals from a Roth IRA, no matter how old you are.  With traditional IRAs, you generally must take at least required minimum distributions (RMDs) after age 701/2.  Therefore, a Roth IRA can be ideal if you have ample wealth from other sources and wish to pass a tax-free account to your heirs.
• Example1:
  • Barbara has $1 million in a traditional IRA.  She converts the account to a Roth IRA in 2010 and owes $350,000 in income tax, at a 35% rate.  Barbara pays that tax bill with non-IRA funds.
  • Assume that Barbara lives for 24 more years.  She earns 6% per year in her Roth IRA and takes no distributions.  Therefore, the account is worth around $4 million at Barbara’s death. If Barbara’s son Phil is the beneficiary of the Roth IRS, he will be subject to an RMD schedule, but all of his withdrawals will be tax free.

TAX TACTICS

• When you convert a traditional IRA to a Roth IRA, you will have to recognize income from the conversion.  That income may help you use up tax benefits that otherwise would be used later or not at all.  Tax benefits that may expire for lack of income include net operating losses, ordinary losses, and charitable contributions.
• Example 2:
  • Nick is a retiree with modest taxable income.  A few years ago, he made a large donation to his alma mater.  Under the tax code, Nick’s charitable deductions each year are limited to 50% of his income.  If Nick doesn’t use all of his deductions within five years after the year of the donation, he will never be able to use them.
  • There, Nick converts his traditional IRA to a Roth IRA.  This move increases his income, enabling him to use the balance of his charitable deduction.  Thus, Nick has converted his tax-deferred traditional IRA to a potentially tax-free Roth IRA while incurring a relatively low tax obligation.

MARKET TIMING

• If your traditional IRA loses value, you will owe less tax on a Roth IRA conversion.  Many taxpayers invest IRA money in stocks.  Because the broad U.S. stock market is currently below its peak, Roth IRA conversions are relatively inexpensive.
• Example 3:
  • Robin Bradley’s traditional IRA was worth $300,000 in late 2007.  In her 33% tax bracket, Robin would have paid $99,000 in federal income tax to convert this IRA to a Roth IRA.
  • Robin’s traditional IRA is now only worth $210,000.  She would owe $69,300 on a Roth IRA conversion, at a 33% tax rate: $29,700 less than a conversion would have cost in 2007.  If Robin’s Roth IRA grows back to $300,000, she eventually can withdraw that $90,000 without owing any income tax.  Without a Roth conversion, Robin would owe income tax on withdrawals from her traditional IRA, making that $90,000 gain taxable.

RETIREMENT PLANNING

• Some taxpayers believe they will be in a higher tax bracket in retirement than they are now.  They may have low taxable income this year, for example, or they may plan to relocate to a high income tax state.  In addition, many people fear that future income tax rates will be higher than today’s rates because the federal government will need more money to cover its obligations.
• In such circumstances, you might want to convert all or part of your traditional IRA to a Roth IRA now and pay tax at current rates.  Once you meet the five year and age 591/2 tests, you will have a source of tax-free cash no matter what happens to your personal tax rate.

WHY YOU SHOULD NOT CONVERT

• You cannot convert the 2010 RMD amount from the traditional IRA to a Roth.
• The tax liability is too large.  It is not advisable to use part of the IRA conversion money to pay the tax due. Does paying the tax deplete too much of your liquid cash assets?
• Is the conversion going to bump you into a higher tax bracket so all your income will be taxed at a higher rate? The amount of Roth transfer is treated as income.  If you receive Social Security benefits, their taxability will be affected and some deductions could be reduced that are affected by income limits.

I tried to keep this letter brief, but as you can see there are many things to consider if you are contemplating doing a conversion.  There are too many variables to cover in a general article, so it is best to consult your financial advisor or CPA to analysis your particular situation.

Should you have questions regarding this post or any other tax needs, contact us at Schutte & Hilgendorf, PLLC, Prescott accountants serving the greater Yavapai County with tax, accounting, auditing, and QuickBooks consulting expertise.