Roth Conversions

If you haven’t heard about Roth IRA conversions, you will soon. A new tax law goes into effect this January. This new law was part of the old administration’s tax overhaul, and it clearly affects higher income earners, depending on what you call “higher.”

Up to now you could convert your old Traditional IRA into a Roth IRA only if your Adjusted Gross Income (AGI) was under $100,000. In other words, folks with modest incomes have always been able to do a conversion; folks with higher incomes could not.

But starting in 2010, individuals with incomes over $100,000 will be able to convert their Traditional IRA account into a Roth IRA account. You can bet that every bank, insurance company, mutual fund, and broker knows this and sees this as an opportunity to have the “rich folks” convert their existing Traditional IRAs to a new Roth IRA with them.

Expect the advertising to begin shortly.

How does this affect you? Does this affect you? Should you do anything about it? To understand my answers to these questions you first need a background on IRAs. What’s nice is that even if you have no plans on doing a conversion, you’ll learn more about the two IRA types. After your IRA review, we’ll look at the conversion process and what you’ll want to consider before making up your mind to convert or not.

Let’s start first by looking at the similarities between the two types of IRAs.

Review of Traditional and Roth IRAs

Account: An IRA is not an investment; it is a type of account that you then put investments into. As long as the money stays in the IRA account, any income or growth it experiences is shielded from taxes. Both Traditional and Roth versions have this tax deferral feature.
 

How much you can put into an IRA is based on your earnings and your age. If you are under the age of 50 you can put in up to $5000 per year in your IRA. If you are 50 years of age or older, you can put in up to $6000. This maximum is also restricted to your earned income. Your annual contributions cannot be more than your income from employment.

There is another limit that applies only to Roth IRAs. With Roths, you cannot contribute if you make $120,000 or more if single, $176,000 if married filing jointly. (There are phase-out provisions as you approach these numbers.) Therefore, higher income earners are often limited to contributing only to Traditional IRAs.

Contributing to a Traditional IRA

One main difference between Traditional and Roth IRAs is the tax-deductibility of your contributions. With a Roth IRA you are never allowed to deduct contributions from your taxable income. A Traditional IRA may provide an income tax deduction depending on your taxable income and whether you or your spouse is covered by an employer-sponsored retirement plan.

If you’re married, are covered by a work plan, and make less than $89,000, you get to deduct your Traditional IRA contributions from your income. If you make over $109,000 you still can make contributions, but you don’t get the tax deduction. Between those two numbers there is a phase-out. For singles the phase-out is from $55,000 to $65,000.

If neither you nor your spouse is covered at work, then no matter how much income you make, you get to deduct your Traditional IRA contributions. If you are not covered by an employer-sponsored plan at work but your spouse is, then your phase-out is from $166,000 to $176,000. Let’s look at a couple of examples.

In our first example, let’s say you are married and you show $75,000 in taxable income on your joint return. You decide to make a contribution to your IRA of $5,000. This would decrease your taxable income to $70,000. That reduction saved you $1,250 in taxes. That’s a great benefit, and the reason so many people use Traditional IRAs.

But now let’s change things. You’re married, have a 401k at work, and your family has $120,000 of taxable income. The 401k is a type of employer-sponsored plan. Since you have over $109,000 of taxable income, none of your IRA contributions is deductible. In that case, you’d probably want to consider a Roth IRA instead.

However, if you are married and make over $176,000 then you are not allowed to contribute to a Roth IRA. In this case, you would be limited to a non-deductible, Traditional IRA (deductible, if not part of an employer retirement plan). That’s not a bad thing, it’s just not as good a deal as lower income earners get.

Getting Money Out Of Your Traditional IRA

The magical number in this story of withdrawing money from your Traditional IRA is 59½. That’s because once you each reach the age of 59½ you can begin taking distributions from your IRA without a penalty. Drawing money from an IRA prior to age 59½ may subject you to a 10% penalty. The reason I say “may” is that there are circumstances that allow earlier withdrawal without penalty.

These exceptions include a permanent disability to the IRA owner, distributions taken to pay for non-reimbursed medical expenses (as long as they are in excess of 7.5% of your Adjusted Gross Income), and distributions to pay medical insurance premiums if you have been out of work for at least 12 weeks. You can also take a distribution for a first time home purchase (lifetime limit of $10,000), higher education expenses, and a few other exceptions.

While not having a penalty is good, it doesn’t get you out of paying taxes. You’ll remember from last week, that often you get to take a tax deduction for contributions to your Traditional IRA. Since you didn’t pay taxes on the money on the way in, the IRS wants taxes on the way out.

It does this by having you add to your taxable income the amount you withdraw from your IRA. For example let’s assume that you have $50,000 of taxable income. You withdraw $10,000 from an IRA and none of that money had been previously taxed. In that case the $10,000 withdrawal is added to your $50,000 of taxable income so that the IRS wants taxes on $60,000.

Some of you may think you’ve found an out from paying taxes. Just never withdraw the money. Let your heirs worry about it. Well, the IRS won’t let you keep your Traditional IRA intact forever. Once you reach the age of 70 ½ the IRS requires you to start taking these distributions. These are called “required minimum distributions” (RMD).

These calculations are determined by the Internal Revenue Service using a lifetime expectancy table. The most commonly used is called the Uniform Lifetime Table, which lists a distribution divisor based off of lifetime expectancy. The distribution is calculated by taking the account balance at the end of the prior year and dividing that amount by the divisor from the IRS table.

“What if I don’t need the money?” you ask. Well too bad. Failing to take your RMD results in a whopping 50% penalty of the amount that should have been distributed. However, if you can convince the IRS that the distribution was not taken due to a “reasonable error”, and that you are taking steps to rectify the situation, they might waive the penalty. Good luck with that.

The good news is that as part of the stimulus package the IRS has waived the RMD for 2009. They didn’t want you to have to cash out your investments at a loss and then pay taxes on them, adding insult to injury. But next year you’ll have to start up again.

Special Features of the Roth IRA

A Roth serves the same purpose as the Traditional IRA: to supplement your income at retirement. So, what are the differences? We’ve already seen how higher income earners may not be allowed to contribute money to a Roth. For instance, married filers making under $166,000 can make a full contribution, and those making $166,000-$176,000 are placed into the phase-out category. The “phase-out” category means that you can still make a contribution into a Roth, but just a partial one based on your income level. Make more than $176,000? No Roth for you. (Single filers have a similar phase-out, from $105,000 to $120,000.)

Contributions made into a Roth, unlike most Traditional IRAs, are not tax deductible. So why do so many people suggest contributing to a Roth? Well, for starters, there is no mandatory age that you must start taking distributions. The age 70½ Minimum Required Distribution discussed earlier doesn’t apply.

But the most important reason that many like the Roth over a Traditional IRA is that once you reach 59½ years of age (and you’ve had the account for at least 5 years), you can take distributions from the Roth and pay NO taxes. Let’s say you contributed $50,000 into a Roth, and the value skyrocketed to $150,000; that’s an additional $100,000 tax free money. Woo-hoo! Tax free is nice.

As a bonus, you can always withdraw the amount that you put into a Roth without paying taxes on it even if you’re under 59½.

A Quick Summary

So let’s summarize what we’ve learned up to now:

Traditional IRAs may provide you with tax-deductions for the amount you contribute each year. Earnings grow tax-deferred. It’s only once you make withdrawals that you’ll have to pay taxes.

Roth IRAs provide no tax deduction for contributions. But if you keep them until at least 59 ½ years of age (and at least five years), you can take out any or all of the money completely tax free.

With either IRA, if you take out money early, you’ll owe a penalty, with some exceptions.

Both have the benefit of helping you save for retirement and save taxes at the same time.

For some of you, the Traditional IRA makes the most sense, for others the Roth IRA is a better idea. And if things change, there is a way to convert a Traditional IRA into a Roth IRA.

Roth IRA Conversions

We are finally getting around to discussing what Roth IRA conversions are and whether you might want to do one.

The basic reason you’d want to convert a Traditional IRA to a Roth is to get that tax-free withdrawal feature that only the Roth IRA has. You also won’t have to make those pesky RMD withdrawals after age 70 ½.

To do a conversion, you simply tell the firm holding your Traditional IRA that you want to convert it into a Roth IRA. Partial conversions are allowed. Once you fill out the appropriate paperwork, they’ll move whatever holdings you designate from the Traditional to the Roth IRA. (Remember, if you make a modified adjusted gross income over $100,000 you’ll have to wait until 2010.)

There is one little problem with this. When you do a conversion, anything coming out of the Traditional IRA is taxed. The IRS looks at the value of what you are converting and adds it to your taxable income. But at least when you do the conversion there will be no penalties on what you convert.

While that may seem like a deal-breaker, it is really just the same decision you must make in determining whether you want a Traditional IRA or a Roth. Do you think that the tax savings now by using a Traditional IRA is worth more or less than the tax savings in the future from the Roth IRA? You’re going to pay taxes either on the amount you put in or the amount you take out—which is up to you.

If you are in a very high tax-bracket now and expect to be in a very low one when you retire, then the Traditional IRA might be better for you. For most of the rest of you, a Roth might be better. However, you really need to run the numbers to know. There are calculators on most of the major mutual fund and brokerage web sites to help, or you can run the numbers yourself if you understand the tax rules.

The problem is that most all of this requires you to make some assumptions. How long until you will need to withdraw from the IRA? What will your tax bracket be in the future compared to your current one? What rate of growth will you earn in your IRA across time? These and more need to be guessed at before you can calculate which type of IRA is best for you.

There are further aspects to a conversion that complicate this a bit. After all, where are you going to get the money to pay for the taxes due to the conversion? If you don’t have the money sitting in a non-IRA account, this might not be a very good deal for you. Using funds from the IRA to pay the conversion taxes depletes the benefits of the conversion process. In addition, if you are under 59 ½ years of age, the 10% penalty will apply for taking a distribution to cover the taxes.

Conversion Considerations

Now let’s take a gander at the much discussed 2010 Roth conversion. Until now, those with adjusted gross incomes of $100,000 or more were not eligible to do a Roth conversion. This will change in 2010, and even comes with a few extra perks.

As you now know, in converting a Traditional IRA into a Roth you must pay the taxes now on the converted money. In 2010 only there is a silver lining to this tax cloud. If you complete the conversion in 2010, the government is allowing you to split the taxable income owed due to the conversion over your 2011 and 2012 tax years.

Another perk (though it may not feel like it) is the decreased value of your portfolio at the time of conversion. Over the last year and a half many of us watched in horror as our values dropped considerably. By converting to a Roth now, you are paying the taxes on a much smaller amount. Once the securities rebound, you will likely have a much higher value in your Roth, and all of it will be tax free.

While it sounds like all of the restrictions on Roths are being lifted, that’s not completely the case. The contribution limits are still in place. Those making over a certain income are still not able to make new contributions, only conversions, at least for now.

If this sounds like something you might be interested in, there are a few more things to consider. One of these is potential changes in the future tax laws. We can’t predict the future, and are assuming the current tax laws will remain the same. Tax laws have changed before, and more than likely will change again in the future. Many seniors counted on tax-free income from municipal bonds, but are now having to pay extra taxes on their Social Security income because of it (which itself used not to be taxable). Will something like that happen with converted Roth funds? We won’t know until that time comes along.

However, at the same time, we are likely going to see higher tax rates in the future—especially for those in the higher income brackets. This makes the Roth conversion even more valuable.

And consider that there is a five-year holding period for Roth conversions. This means that the funds you convert must stay in the account for at least five tax years (or until you are 59 ½, whichever is longer). Taking a distribution prior to that period will result in a tax penalty you weren’t planning on.

IRAs themselves are great to have for some people, while they don’t make sense for others. The same is true with conversions from Traditional to Roth IRAs. Now you know the basics. The rest is up to you.

A Word of Warning

All of this can get a bit complicated. There are many “ifs” that I haven’t included in my discussions and I’ve left some of the nuances out of the discussion.

Also, this was written in November of 2009. Things change—especially the tax laws, so make sure you get current guidance before doing anything. In other words, it would not be a bad idea to also discuss the ramifications of a conversion with your financial and tax advisors or research this further on your own.

Thanks and Acknowledgements

Many thanks to Michelle Kuehner (research and initial draft), Alex Carracedo (technical corrections), and Mona Statser (grammatical corrections) for their assistance in this series of articles.