01/14/2009

One Benefit To Today's Bear Market: A Roth IRA Conversion In 2010 May Reduce The Taxes Due On Your IRA Assets

While the severe market declines in the last year have reduced the balances of traditional IRAs, the declines have not had an immediate tax effect.  The reason is that losses, as well as gains, are not recognized within a traditional IRA. Given the continued bear markets, however, there are certain tax strategies pre-retirement age investors owning traditional IRAs should consider.

One of these strategies is to convert a traditional IRA into a Roth IRA to take advantage of future tax-free growth and tax-free distributions at retirement. While such conversions are restricted to investors with modified adjusted gross incomes (MAGI) of $100,000 or less in 2009, the restriction is lifted in 2010. Accordingly, beginning in 2010, Roth conversions become a tax strategy available to many high wealth investors affected by bear market conditions.

The following discussion is intended to provide a general overview of the traditional IRA to Roth IRA conversion process. Given the detailed rules and regulations governing both traditional and Roth IRAs, a comprehensive analysis of the Roth conversion process is beyond the scope of this article. An investor considering a conversion to a Roth IRA should consult with the investor’s tax advisor before undertaking any conversion.

Traditional IRAs and Roth IRAs

In this article, reference to a “traditional” IRA means an IRA in which the investor generally contributes tax deductible dollars or, for high income taxpayers, after tax dollars are contributed. In a traditional IRA, no tax is paid on income earned on contributions until the retirement savings are distributed, at which time the distributions are generally taxable. Traditional IRAs are subject to rules which require minimum distributions at age 70 1/2 and which penalize excess contributions, premature (before age 59 1/2) distributions, and certain distributions deferred beyond age 70 1/2.

Roth IRA contributions are not tax deductible and contributions are limited based on MAGI limits. Roth IRAs are not subject to required minimum distributions at age 70 1/2, and if the account has been in existence for five years and the owner is age 59 1/2, the owner can withdraw principal and earnings from the IRA free of income taxes.

2009 and 2010 Roth Conversion Rules

In 2009, investors (other than married investors filing separate tax returns) with MAGI of $100,000 or less may convert a traditional IRA to a Roth IRA in one of three ways:

• A rollover to a Roth IRA of a distribution from a traditional IRA within sixty (60) days of the distribution;
• A trustee-to-trustee transfer from the trustee of the traditional IRA to the trustee of the Roth IRA; and
• A transfer of an amount in a traditional IRA to a Roth IRA maintained by the same trustee.

For purposes of conversions to Roth IRAs, MAGI does not include any income resulting from the actual conversion from a traditional IRA to a Roth IRA. However, the conversion to a Roth IRA is subject to tax as if the converted funds were distributed from the traditional IRA and not recontributed to another IRA, but is not generally subject to a 10% premature withdrawal penalty. The 10% premature withdrawal penalty may apply, however, if the investor uses a portion of the converted traditional IRA funds to pay the conversion tax.

In 2010, the $100,000 MAGI limit on conversions of traditional IRAs to Roth IRAs is eliminated and married investors filing separate tax returns also may convert amounts held in a traditional IRA into a Roth IRA. Roth conversions in 2010 are also subject to income inclusion rules which generally provide that unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010. In that case, half of the income resulting from the conversion is includible in gross income in the year 2011, and the other half in the year 2012.

Analysis of a 2010 Roth Conversion

One of the factors that makes converting a traditional IRA to a Roth IRA in 2010 an attractive option is a continued bear market. This is because the Roth conversion tax is imposed on the value of the traditional IRA assets on the date of conversion. The lower the value of the converted traditional IRA assets on the date of conversion, the lower the conversion tax will be.

The current bear market has decreased the value of many traditional IRAs to their lowest levels in years, thus allowing conversion of a traditional IRA to a Roth IRA at a much lower tax cost. The benefit of converting a Roth IRA at a low level is that the future appreciation and income will be tax free. As the Roth IRA recovers from the bear market, the value that would have been taxed as ordinary income before the bear market will be tax free after the conversion and recovery.

As an example, assume an investor had a balance of $600,000 in a traditional IRA at its peak, but in 2010 the balance fell to $300,000 due to market conditions. At the peak, the investor’s traditional IRA had an after-tax value of $390,000 assuming a tax rate of 35% (600,000 – 210,000 in taxes due). Converting to a Roth IRA in 2010 would incur $105,000 in income taxes ($300,000 x 35% tax rate). Assuming non-IRA funds would be used to pay the conversion tax and the investor’s tax rate remains constant, then if the account returns to its historical value after the conversion, the after-tax value of the Roth IRA to the investor would have increased to $600,000 – an increase of $210,000 ($600,000 less $390,000). The net benefit to the investor would be $105,000 ($210,000 increase – $105,000 tax).

Of course, the conversion would cost $105,000 in present dollars. This $105,000 could have been invested and generated its own return. Therefore, an investor must consider whether the net result would be greater if: a) the investor undertook the Roth conversion and paid $105,000 in tax now; or b) kept the $105,000 and invested it but paid $210,000 in tax on the IRA assets at a later time.

The above analysis highlights two additional factors investors must consider in assessing whether to undertake a Roth conversion. First, does the investor have other, non-IRA funds available to pay the conversion tax? If not, the investor may be subject to the 10% premature withdrawal penalty, making the Roth conversion much less attractive. Second, does the investor anticipate a tax rate in retirement that will be lower than the investor’s tax rate on the conversion date? If so, the Roth conversion will also be much less attractive.

Even in situations where the tax benefit of a Roth conversion is not significant, an investor may nevertheless choose to convert the traditional IRA to a Roth IRA. For example, consider an investor who does not need the IRA funds in retirement but values that the Roth IRA does not require minimum distributions and that the Roth IRA funds may pass tax-free to heirs. In this situation, a Roth conversion which has no current income tax benefit may still be worthwhile to the investor.

Investors considering a Roth conversion in 2010 must keep in mind that tax laws will continue to evolve between now and 2010. New legislation modifying or repealing the Roth conversion provision, even before it takes effect in 2010, is possible. Accordingly, investors should consult with their tax advisors before undertaking any Roth conversion.

Practice Pointers

1. The best candidates for Roth IRA conversion in 2010 are owners of traditional IRAs which were hard hit by recent market declines, but who have other assets which could be used to pay tax on the conversion.
2. Advisors who are helping clients with a potential Roth IRA conversion should consider the anticipated present and future tax rates for their clients, as well as the anticipated return the clients could achieve on any funds used to pay current tax.
3. Owners of traditional IRAs considering a Roth conversion in 2010 should begin setting aside non-IRA assets now sufficient to pay the anticipated Roth conversion tax. Investors who utilize converted IRA assets to satisfy the Roth conversion tax may be subject to the 10% premature withdrawal penalty.
4. Owners of traditional IRAs considering a Roth conversion in 2010 may incur very little risk in the conversion process. If circumstances change or there is a mistake in the investor’s assumptions, the investor may be able to reverse the Roth conversion in a process known as recharacterization which treats the Roth conversion as if it had never been made.
5. Owners of traditional IRAs who do not believe they will need their IRA funds in retirement may utilize a 2010 Roth conversion as an estate planning tool. The owner pays the conversion tax in 2010 (or 2011 and 2012 if the deferral is elected) and the owner’s heirs will not have to pay income taxes on those funds when they receive their inheritance.