Roth IRA Conversions

Changes in legislation often serve as the impetus for the Wealth Management Newsletter’s monthly topic. January is no exception: we begin the year with new opportunities for Roth conversions.

Roth IRA conversions permit an investor to change (convert) his or her traditional pre-tax IRA into a Roth IRA, which allows tax-free withdrawals. Currently, there are two conditions that must be met before a conversion can take place: taxes must be paid on the amount converted, and there is a $100,000 adjusted gross income limitation.

Two pieces of legislation have made the conversion process easier. As of 2008, taxpayers will be allowed to complete a Roth conversion by directly rolling retirement plan assets, into a Roth IRA, once they end employment. Income limits apply ($100,000 adjusted gross income) and taxes must be paid on pre-tax contributions and earnings. This opportunity works best when there is after-tax money available within the retirement plan that can be rolled over, tax-free, into the Roth. The direct Roth Conversion helps to prevent co-mingling of pre-tax and after-tax money in a traditional IRA, which can be a record-keeping nightmare and complicate the conversion process.

Another Roth rule was passed in May of 2006 (TIPRA Tax Increase Prevention and Reconciliation Act), but doesn’t apply until 2010. TIPRA eliminates the $100,000 adjusted gross income ceiling for converting a traditional IRA to a Roth IRA, beginning in the 2010. In addition, individuals can spread out the taxes owed, as a result of the conversion, over two years: 2011 and 2012.

We mention this now because individuals currently not eligible for pre-tax IRA or Roth contributions might consider making non-deductible contributions to their traditional IRAs for 2007, 2008 and 2009. The after-tax cost basis will escape taxes in the conversion process, thereby building larger balances in a Roth. This strategy works best if your current traditional IRA is relatively small and doesn’t receive a large retirement plan rollover in the next few years.

Who should convert? People who --

1) Believe that their marginal tax brackets will either rise or remain the same in the future.

2) OR plan to leave Roth balances to their heirs. A Roth IRA does not require minimum distributions at age 70 ½ for the initial owner and can thus be transferred in its entirety to heirs. You will be paying the taxes now so that your heirs do not have to pay the taxes in the future.

3) OR will receive most of their retirement income from pensions, IRAs or retirement plans which are fully taxable. A Roth provides a tax-free income source that can be used to reduce a given year’s income tax liability.

4) AND has the necessary money saved OUTSIDE OF the traditional IRA to pay for the income taxes. A Roth conversion only makes sense if an individual does not need to use the conversion money to pay for taxes.

Finally, many people confuse the timing of Roth conversions with deadlines for IRA contributions. While you can contribute to your Roth or traditional IRA for the current year up until April 15^th of the following year, a Roth conversion always applies to the year in which it is completed.