The opportunity to convert funds from Traditional IRAs to Roth IRAs has been around since 1998, but it is only now that Congress is getting it right.

 

As of January 1, 2010, the income limits that stopped too many American taxpayers from

converting a traditional IRA or an employer-sponsored retirement plan to Roth IRAs no longer operate.

 

Roth IRAs are generally attractive savings arrangements for older, upper bracket taxpayers.   It is noteworthy that the new rules activate when many IRAs have suffered significant investment losses. While the decline in value may cause concern, given the down market, income taxes on such conversions (tax, but not penalty is due on the withdrawal from the traditional IRA ultimately transferred to the Roth.) may be lower. 

 

A meaningful advantage to the Roth IRA is that (presuming the Roth IRA was held for five years and its owner is at least age 59½) when the Roth money is distributed, there is no income tax on either the (never deductible) contributions or on the earnings. Those presuming that tax rates are historically low and likely to rise may find the Roth arrangement especially appealing. This tax treatment operates in contrast to that associated with the Traditional IRA in which-- since the contributions may have been deductible--withdrawals of contributions and earnings are typically taxed at the owner’s highest ordinary income tax rate. Additionally, while withdrawals from Traditional IRAs must begin no later than April 1 of the year following the year the owner attains the age of 70 ½ there is no requirement to take distributions from Roth IRAs during lifetime. Clearly, the Roth IRA offers remarkable intergenerational tax and distribution planning opportunities when the owner’s children and grandchildren inherit the Roth proceeds.

 

Understanding the advantages of the Roth generally sparks interest in converting from the Traditional to the Roth. However, through 2009, many taxpayers run into a snag: Those with tax returns showing modified adjusted gross incomes over $100,000 would not be permitted the conversion. Think this through: If the taxpayer has to pay tax on the rollout of funds from the Traditional IRA, but can’t earn more than these income limits, the field of taxpayers eligible to make the conversion is quite small. Incidentally, married taxpayers who file taxes separately could not convert, period.

 

As part of the 2006 Tax Increase Prevention and Reconciliation Act, beginning on January 1 2010, the $100,000 income limit for Roth conversions, as well as the restriction on spouses who file separate tax returns are gone forever. That should enable more taxpayers having higher incomes to convert to Roth accounts. The changes also permit more workers and retirees who once rolled over their holdings from 401(k)s and other employer-sponsored retirement plans into Traditional IRAs to convert to Roth arrangements.

 

Regardless of the amount of one’s Modified Adjusted Gross Income, reality does surface. Taxes are due on the Traditional IRA distribution. However, to encourage Roth Conversions (and, frankly, the tax revenues they generate), Congress dishes out yet another tax break. The taxpayer can report the amount converted in 2010 on his 2010 tax return, or he can spread the amount converted equally across both the 2011 and 2012 tax years, paying any resulting tax with those returns. For example, say Connie Converter transfers $50,000 from her traditional IRA to a Roth next year and decides not to report the conversion on her 2010 income tax return. Thus, she must declare $25,000 on her 2011 tax return and $25,000 her 2012 return. The two-year tax spreading opportunity will only be available for 2010 conversions.

 

The end of the income limitation on conversions offers even more tax planning sunshine. Since the Roth IRA was first established in 1998, taxpayers with modified adjusted gross incomes over certain amounts in 2009, ($120,000 for a single filer or $176,000 jointly) couldn’t even contribute to a Roth. While they could probably contribute to a Traditional IRA, the income limitations made the Roth conversion unattainable. In 2010 and beyond, with the elimination of income limits on conversion, little prevents a savvy high-income taxpayer from first contributing to the traditional account, then converting to a Roth. 

 

-- Carla Gordon, CFP ®, MSFS serves as Zahn, Inc. Chicago-based instructor.  Since 1986, she has helped thousands of individuals to pass the rigorous CERTIFIED FINANCIAL PLANNER ™ Examination and the National Stockbrokers Exam. (Series 7).