"Roth conversions can trigger unintended tax traps and financial problems that are not being addressed in the mounds of 2010 Roth conversion information that currently dominates the media, " Ed Slott wrote recently in his newsletter, "Ed Slott's IRA Advisor."
Biechele Royce Advisors is fielding an increasing number of inquiries from clients and the public regarding Roth conversions. Roth conversions are a hot topic because the income cap for conversions was removed permanently starting in 2010 and the IRS is allowing investors to defer taxes on converted IRAs in 2010 only, until 2011 and 2012 (You can choose to pay 100% of the taxes owed in 2010 or pay tax on half the converted amount in 2011 and on the other half in 2012). A quick review of the main differences between a Roth and a regular IRA might help frame the conversion discussion.
IRAs are funded with pre-tax dollars, reducing an investor's tax bill in the year of the contribution. IRA investments grow tax deferred, but an investor is required to pay income tax on all distributions, which are allowed without penalty when the investor turns 59 1/2 years-old. Required minimum distributions (RMD) kick in once the investor turns 70 1/2. The Roth IRA is funded with after-tax dollars, which means no reduction in your current tax bill. However, you will never pay tax again on your Roth investments and there are no required distributions, making the Roth a very attractive option for anyone who meets the income requirements.
Investors have had an option to convert from an IRA to a Roth for years, but only if they made less than $100,000 annually. All investors are eligible to convert staring in 2010 however, and many investors are weighing the pros and cons as a result. Unfortunately, there is no simple answer to the conversion question and each situation must be reviewed individually. There are, however, a couple of basics to keep in mind when deciding whether a conversion makes sense. Roth conversions are most appealing to clients who have significant IRAs and wouldn't touch them if it weren't for the required minimum distributions (RMD). Roth IRAs are a much better estate planning vehicle since investors aren't required to take RMDs and can therefore leave more assets in a tax free investment vehicle for future generations. And unlike an IRA, which requires beneficiaries to pay income tax on inherited IRAs when taking distributions, Roth IRA distributions are tax free! As well, conversions are attractive to those investors who would owe very little additional income tax on conversion. Future expected income tax rates figure promonently into your calculations here. Income taxes are expected to rise sharply in coming years, which means many of us might be in a higher income tax bracket in retirement, making a conversion now more appealing. On the other hand, you may have less income in retirement, putting you into a lower tax bracket. One last piece of advice on conversion: it is almost never a good idea to pay the taxes generated from a conversion from the IRA since you want as much of your money to grow tax free as possible. Consequently, conversion becomes much less attractive if you don't have money set aside to pay the taxes. The bottom line on the conversion question? Consult with a trained investment professional (CFA) or a CPA for guidance.
Now that you've decided to convert, making sure to avoid the numerous tax traps and pitfalls takes some planning.
First, investors who choose to split the tax bill must understand that it is highly unlikely that the tax bill will be the same in 2011 and 2012. The total tax bill will depend on various factors including tax rates (which could well go higher) and overall income. Also, beware paying the conversion tax with IRA money if you are under 59 1/2 - you will unwittingly trigger the 10 percent penalty. You will also trigger the 10% penalty if you withdraw converted money within 5 years of conversion if you are under 59 1/2. Simple IRAs have a two-year holding period and can not be converted sooner; the IRS will treat it as a taxable distribution! Non-spouse beneficiaries can't convert an inherited IRA but can convert an inherited plan. Don't roll the inherited plan into an IRA and then try to convert or you will have a problem. As well, rolling a plan mid-year into an IRA after converting your IRA to a Roth will lead to a bigger tax bill than anticipated given how the pro rata rule is calculated (only applies if you have basis in your 401(k). Also, for those of you who are already taking required minimum distributions (RMD), you can't roll your entire IRA into a Roth without first taking the required distribution - you will owe taxes one last time! Oh, and for those of you hoping your child will qualify for tuition assistance... remember that tuition assistance is based on income not retirement assets. Converting your IRA to a Roth may disqualify your child from receiving assistance!
There are a number of other tax traps and gotchas that you must carefully consider before making your conversion. Please consult a knowledgeable investment professional before converting willynilly and inadvertently triggering unnecessary taxes and penalties. Qualified professionals include CPAs, CFAs, and CFPs.
