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ROTH IRA Conversions in 2010 - Advantages and Disadvantages

Starting on the first day of 2010 there was a major change relating to Roth IRAs. In past years if taxpayers had over $100,000 in modified adjusted gross income (AGI), they could NOT convert (roll over) other retirement plans into a Roth IRA.  This AGI limit was lifted starting on January 1, 2010 and going forward there are NO income limitations upon who may convert their retirement funds into a Roth IRA.

One quick reminder: In a Roth IRA there are no current deductions for making a contribution to the plan. However, if the Roth is established at least five years, ALL withdrawals are tax free (including all earnings on the plan).

Also, there is a special benefit if you convert your retirement funds to a Roth IRA in 2010. Taxpayers have a default option to defer the income relating to the conversion over the following two years. The taxpayer would include one half of the taxable rollover in his or her gross income for 2011 and the other half in 2012, rather than picking it all up in 2010. This special feature is only for 2010 Roth IRA conversions. If the taxpayer wanted to pick up all the Roth conversion as taxable in 2010, he or she would actually have to elect to do this rather than the aforementioned option.

With the expected expiration of the Bush tax cuts after 2010 and potential for additional taxes under the Health Care bill, the current bet is that tax rates will go up from their 2010 level. Taxpayers need to consider the tax consequences for the year(s) in which they pick up the income relating to the conversion. With the top four tax rates now being 35%, 33%, 28% and 25%, after 2010 the top four tax brackets automatically rise to 39.6%, 36%, 31% and 28% (plus a possible surtax for Healthcare). A tax strategy that many taxpayers have been advised to use in the past, which is to accelerate deductions and defer income, may no longer apply in the year of conversion.

There is a lot of discussion about the virtues of converting your 401(k), IRA or other retirement plan into a Roth IRA. There are also many complex software programs that will tell you that assist you in calculating how many years it takes to come out ahead if you pay the taxes now. One example we have seen, if you roll over your IRA, earn 7%, are in the 28% bracket now and the 31% bracket in the future in 17 years, you are ahead paying tax now. Unfortunately, as you can see, trying to determine if a Roth conversion is favorable takes a lot of guesswork about the future. Also, it is likely that rather than a static future income tax rate, one could realize different tax rates in each of the future years. Consequently, we have put together some general thoughts to be considered prior to converting to a Roth IRA. 

Potential Advantages:

1. A Roth IRA does not require its original owner to begin withdrawals at age 70 1/2 like other retirement plans. As a matter of fact, during the original owner's lifetime, no withdrawals are required.
2. You have outside funds to pay the tax on the conversion. This is almost like getting additional funds into your retirement account.
3. "You already have more than adequate funds outside the IRA to live on the rest of your life. Therefore, the payment of tax reduces your taxable estate and, in essence, results in your paying the income tax on the retirement funds for your heirs.
4. You had been making nondeductible IRA contributions and, therefore, upon withdrawal, a good portion of your IRA isn’t taxable on the conversion, especially considering market performance over the past couple of years.
5. Your investments earn a much higher rate of return than you had estimated prior to converting the funds to a Roth.
6. Income tax rates go up for YOU. Don’t confuse this with the expectation that income tax rates overall are going to go up

Potential Disadvantages:

1. Congress changes its mind and slaps an “excise” tax on all withdrawals from Roths or, at least, on Roths with large balances.
2. Congress changes its mind and terminates the tax-free growth inside a Roth.
3. The taxpayer winds up in a much lower bracket in his or her retirement years than initially anticipated.
4. The taxpayer will have to utilize funds from the IRA to pay the additional tax on conversion and then winds up with an additional 10% penalty on funds NOT converted.
5. The retirement account goes DOWN in value and the taxpayer does NOT timely reconvert back to the original retirement account.
6. Congress enacts a consumption tax such as a Value Added tax or Sales tax and does away or greatly lowers the income tax.
7. A divorce occurs and your spouse gets the Roth account.
8. You plan to give away all or a significant part of your retirement account to charity.
9. You will need funds from the retirement account in less than five years.

Two last points: Remember that a Roth conversion may be undone. As long as the Roth funds are reconverted back to the original account before the time the taxpayer timely files a return for the year of conversion (including extensions), then the conversion is not taxable. This could be as late as October 15 of the year following the conversion. Second, the rollover to a Roth is NOT an all-or-nothing decision. For many taxpayers the advice is, “Don’t put your retirement nest egg in only one type of retirement account; hedge your bet and only convert part of the retirement account into a Roth.”

For more information, please contact John Barsella at 312-980-2905, Michael Calahan at 312.980.2996 or your Blackman Kallick representative.  

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.