Roth IRA Conversion Rules Changing – Have You Reviewed Your Tax Plan? – Part II

October 13, 2009

This is Part II of a series of posts related to Roth IRA Conversions and the rule changes that go into effect on January 1, 2010.  As mentioned in Part I of this series of post regarding Roth IRA Conversions, I will explain the rules around Roth IRAs, as well as what the recent changes in the law means. I will also provide you with some reasons to convert, as well as some reasons not to convert. In addition, my final posts will include some tax planning tips around the Roth IRA.

Part I:  What is a Roth IRA? What is changing about Roth IRA Rules?
Part II:  Reasons to Convert to a Roth IRA.
Part III:  Reasons NOT to Convert to a Roth IRA.
Part IV:  Planning Ideas around Converting to a Roth IRA.
Part V:   More Planning Ideas – What is this Pro-Rata Rule?

In this post, I will explain some of the common reasons for converting to a Roth IRA.  It is important to keep in mind that everyone’s situation is different and that these reasons may or may not apply to you.  You should sit down with your tax professional and do proactive tax planning prior to doing anything.

Reasons to Convert to a Roth.

Low Values in Accounts.  Due to the market conditions over the last few years, many retirement accounts have plummeted in value.  Converting now would allow individuals to pay taxes on this currently deflated value.  Keep in mind though that for this to be an advantage it assumes that the market is going to recover quicker rather than slower.  There is no way to predict if account values will soar back to their prior levels anytime soon.  Nevertheless, it does yield a lower tax bill than it would have if a conversion were done when the account values were at their peak.

Possibility of Higher Taxes in the Future.  Let’s face it, the finances of our nation are in turmoil.  With massive record deficits and an Administration and Congress that are proposing massive new government programs, it is unlikely that we will see income taxes go much lower than they are today.  The federal government rarely, if ever, cut their budget from one year to the next.  It just keeps growing.  Because of this many taxpayers are betting on much higher tax rates in the future – even for retired middle class Americans.  Why does this apply to Roth IRA conversions?  Many taxpayers are choosing to pay the taxes on their retirement money now – at a rate that they anticipate to be much lower than in future years.

Withdrawals are Tax Free.  As long as you have held your assets in your Roth IRA for at least 5 years or are age 59 1/2, withdrawals are generally tax free (special rules apply to earnings that have not been held in an account for 5 years).   Keep in mind that they say this is “tax free,” but the fact is that you have already paid the tax on your contributions in the year that you made them.  What they are really meaning is that you just do not owe tax when you pull the money out because you already paid it.   Also, bare in mind that this “tax-free” status is based on current law, and that does not mean it will be the law when you retire (see below).

Income Tax Deferral Option for 2010.  As part of the law change that goes into affect on January 1, 2010, Congress is allowing taxpayers who convert to a Roth IRA to defer the tax and pay half of it in 2011 and half of it in 2012 based on their tax brackets for those years.  Taxpayers who wish to pay the entire tax due in 2010 may do that also.   While this does not provide a taxpayer an eternity to come up with the money to pay the taxes, it does provide them with a couple of years .  Of course, not converting defers the tax until the funds are withdrawn during retirement.  The biggest advantage here is that if you are converting for other reasons, this gives the taxpayer an option that was not available before.  This option to spread the tax over the following two years is only available for conversions completed in 2010.  This is something that should be discussed during your tax planning session with your tax professional.  The timing of when you pay the tax could affect your tax brackets, your alternative minimum tax (AMT) situation or cause other tax issues.  You want to make sure you do it in the right years.

No Minimum Distributions.  I will discuss some planning ideas around this in Part IV, but another advantage to a Roth IRA over a Traditional IRA is that you are not required to take minimum required distributions (RMDs).  Traditional IRA’s require that once you reach age 70 1/2, you must take a distribution amount that is calculated based on your life expectancy.  This is a negative if you do not need as much money that you are required to pull out.  With a Roth IRA, you can leave the funds in there as long as you wish with no distribution requirements during your lifetime.  See Part IV for some tax planning ideas around the Roth IRA and No Minimum Required Distribution.

Donna Bordeaux, CPA with Calculated Moves

Creativity and CPAs don’t generally go together.  Most people think of CPAs as nerdy accountants who can’t talk with people.  Well, it’s time to break that stereotype.  Lively, friendly, and knowledgeable can be a part of your relationship with your CPA as demonstrated by Donna and Chad Bordeaux.  They have over 50 years of combined experience as entrepreneurial CPAs.  They’ve owned businesses and helped business owners exceed their wildest dreams.   They have been able to help businesses earn many times more profit than the average business in the same industry and are passionate about helping industries that help families build great memories.