Tips on converting IRA to Roth IRA
A topic that has come up in multiple discussions the last few weeks is the Roth Individual Retirement Account (IRA) situation. Specifically, it seems that every financial planner and money manager is touting the conversion of traditional IRAs to Roth IRAs and, in many instances, it makes very good sense to do so. Seldom does it make sense to pay tax on income sooner than the Internal Revenue Service requires it, so there must be some very special circumstances involved. Let’s discuss those circumstances and what exactly is meant by converting an IRA to a Roth IRA.
The process starts with having an IRA. This IRA might have come from making contributions to the IRA or rolling a deferred compensation plan such as a 401k from a job to an IRA. Once the money is in the IRA, the taxpayer can convert the IRA funds into a Roth IRA.
The value at the time of conversion is taxable to the taxpayer. In 2009, the conversion is fully taxable as 2009 income. However, only taxpayers with income of less than $100,000, not counting the conversion amount, are eligible to make conversions. In 2010, the rules change.
First, the taxpayer can elect to pay all of the tax in 2010 for a 2010 conversion, or may elect to defer paying the tax past 2010 and pay tax on 50% of the conversion in 2011 and 50% of the conversion in 2012.
Second, the $100,000 income limitation is eliminated. It is estimated that between two and three trillion dollars in IRAs will be converted to Roth IRAs in the next few years. Yes, that is TWO to THREE TRILLION dollars of conversions. The federal government is going to get an instant infusion of tax revenue of gigantic proportions. Most of this two to three trillion would potentially have been taxed at much lower rates had it been left in the IRAs and withdrawn onlyawhen required. Since required distributions only start at age 70.5, those required distributions might not have started until years down the road.
What would cause people to pay taxes on two to three trillion dollars of income right now? There are a couple of reasons. First, I call it: concern of what’s going to happen in the future. People are worried that tax rates are going to go up substantially in the future. In my humble opinion, these might actually be considered the good old days of tax rates 20 years from now. We might fondly recall the days when a taxpayer with income of $68,000 was taxed at only a tax rate of 15%. So, reason number one for converting that IRA to a Roth IRA would be the lower tax rates we currently enjoy.
Second, monies converted to a Roth IRA grow tax-free from that point forward. This is a big factor. For example, a 60-year-old taxpayer has an IRA that has grown to a value of $150,000. It’s converted to a Roth and the tax is paid. The $150,000 in the Roth grows over the next 21 years to a value of $400,000, when the taxpayer passes away. The $400,000 passes tax-free to his heirs. The growth from $150,000 up to $400,000 is totally tax-free.
This is powerful stuff. If the intent of the taxpayer is to pass on tax-free money to his heirs, the Roth is an excellent vehicle available right now to fulfill that wish. If the IRA was not converted, it would still flow to the heirs, but it would not go to the heirs tax-free. They would be responsible for paying taxes as they took distributions.
In addition, it’s important to note that Roth IRAs are not subject to the Required Minimum Distribution rules which apply to regular IRAs. The taxpayer is never required to take any distributions and, even if he did, these distributions are also tax-free.
So why would someone not want to convert to a Roth? One reason is the taxpayer is going to be using the IRA money to live on. It’s not pass-on-to-the-heirs money. It’s living-on money. If there is any money left for the heirs, that’s nice, but not an over-riding requirement. Any money that’s left, the heirs can pay tax on it themselves.
Additionally, in retirement, most taxpayers drop into a lower tax bracket than when they were working, so as the money is coming out of the IRA, it would be taxed at a lower rate than if it was all converted at once. Why pay tax at a high rate today when it can be taxed at that lower retirement rate tomorrow?
There are other factors that enter into a Roth conversion, so it would pay to discuss this with your tax professional before you make that conversion. This is Jerry Coon signing off.
Jerry Coon is an Enrolled Agent and owns
Action Tax Service on Northland Drive in Rockford.
His telephone number is (616) 866-4704 and his
e-mail address is firstname.lastname@example.org.