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CCH Identifies Important Questions to Answer Before Jumping Onto Roth IRA Conversion Bandwagon
Wealthy Likely to Benefit Most But Everyone Considering Conversions Benefits by Evaluating with Open Eyes
(RIVERWOODS, ILL., January 2010) – While 2010 may be the year of the tiger based on the Chinese zodiac, for wealthy U.S. taxpayers it may very well be the year of the Roth IRA conversion, according to CCH, a Wolters Kluwer business and a leading provider of tax, accounting and pension information, software and services (CCHGroup.com).
Starting January 1, 2010, taxpayers, regardless of income, are allowed to convert funds from their traditional IRAs, 401(k)s or certain other qualified plans to Roth IRAs. Historically, income restrictions had applied. Prior to 2010, a taxpayer’s adjusted gross income (AGI) had to be $100,000 or less in order to be eligible to do a conversion. Additionally, while the AGI restriction is lifted for 2010 onward, taxpayers making a conversion in 2010 will have the added bonus of being able to choose between either paying all the income tax on the converted amount in 2010 or splitting the tax bill evenly over 2011 and 2012, easing the immediate tax burden by distributing it over two years.
“A lot of taxpayers may benefit from making a Roth IRA conversion, particularly people expecting to be in higher income brackets during retirement. But the federal government is the sure near-term beneficiary,” according to Nick Kaster, JD, CCH Senior Pension Law Analyst. “Rather than waiting years to tax distributions from the accounts of these individuals after they retire, the IRS will be collecting taxes as people are making the conversions.”
Although there is significant interest in Roth IRAs and they are a useful retirement vehicle for some, they are not for everyone. According to Kaster, among the questions people should know the answers to before investing in a Roth IRA are:
- What are the tax benefits of a Roth IRA compared to a traditional IRA or 401(k)?
Depending on a taxpayer’s income and active participant status, contributions to traditional IRAs are deductible from income tax in the tax year in which the contribution is made. Distributions are taxed as ordinary income. With Roth IRAs, contributions are made after-tax, but qualified distributions are taken tax-free. With Roth IRA conversions, taxes must be paid in the tax year of the conversion, with the exception of 2010, when individuals can choose to split the tax payments over 2011 and 2012.
- Are there tax pitfalls in making a Roth IRA conversion?
Because the amount a taxpayer converts is added to their taxable income, they should be careful it is not pushing them into a higher tax bracket during the conversion year. If it will trigger a higher tax bracket, they may want to consider making conversions over a few different years.
- Will I have access to my retirement funds in a Roth IRA early if I need them?
If converted amounts are withdrawn from a Roth IRA within five years, a 10-percent additional tax applies unless the IRA owner is older than 59½ or one of the early withdrawal exceptions apply. These include: distributions made to a beneficiary as a result of an account holder’s death; distributions made as a result of the individual being disabled; distributions that are part of a series of substantially equal periodic payments; or distributions used to pay for certain higher education expenses, first-time homebuyer expenses or medical insurance premiums for unemployed individuals.
- Can I pay the Roth IRA conversion taxes from my retirement assets?
Yes, but it’s generally considered better to use non-retirement assets. A purpose of converting to a Roth IRA is to preserve retirement savings, allowing them to grow tax-free and be distributed tax-free. Reducing the value of the account to pay conversion taxes further diminishes retirement savings.
- Am I required to take distributions from a Roth IRA during retirement?
No. Whereas traditional IRAs are subject to required minimum distributions (RMDs) starting at age 70½, Roth IRAs are not. This allows funds to continue to accumulate if they are not needed for living expenses during retirement.
- What benefits do Roth IRAs offer in estate planning?
Because no RMDs are required during the account owner’s life, a Roth IRA is an excellent vehicle to pass on wealth to the next generation. However, upon the account owner’s death, beneficiaries are required to take RMDs, with certain allowances made if the decedent’s spouse is the sole beneficiary.
- When is staying with a traditional IRA or 401(k) better than converting to a Roth IRA?
Individuals who think they will be in a lower tax bracket in retirement, individuals who only have a few years before retirement and plan to take distributions from their Roth IRAs during retirement, and people who cannot afford to pay the near-term taxes on a Roth IRA conversion may not realize many benefits by converting to a Roth IRA.
- Can I change my mind late and convert a Roth IRA back to a traditional IRA?
Yes, but restrictions apply. If a taxpayer changes his mind about a conversion, he can undo the conversion by “recharacterizing” the contribution back to a traditional IRA in a given tax year. He then has to wait until the next tax year before making a “re-conversion” back to a Roth IRA. In addition, at year-end, a 31-day period must pass between recharacterization and re-conversion, meaning he can’t make one move on December 31 and an opposite one on January 1.
“Recharacterization is a useful tool if you make a conversion, the market takes a nose dive later in the year and you find yourself near the end of the year owing significantly more in conversion taxes than you would had you waited to convert to a Roth IRA until after the market turned downward,” explained Kaster.
- How much should I convert to a Roth IRA; do I have to convert my entire 401(k) or traditional IRA?
There is no restriction on the amount that can be converted to a Roth IRA and a person does not have to convert all the funds in his 401(k) or traditional IRA. How much he should convert depends upon a number of factors including how much he can afford to pay in taxes and income needs during retirement.
- Can I make new contributions to a Roth IRA regardless of income?
No. While there are no income limits for conversions to Roth IRAs starting in 2010, income restrictions still apply to contributions. For 2010, single filers must have an AGI under $105,000 and married couples filing jointly must have an AGI below $167,000 to be eligible for Roth IRA contributions. The maximum contribution is $5,000 plus a $1,000 catch-up contribution for people 55 and over.
However, beginning in the 2010 tax year, taxpayers can essentially circumvent these income limits by making a contribution to a nondeductible traditional IRA, which has no income limit, then, converting the nondeductible traditional IRA into a Roth IRA. Such taxpayers would owe taxes only on the earnings in the nondeductible account, if that were their only IRA account. (Otherwise, the tax would be based on the taxable portion of all IRA accounts held.)
- Is it more advantageous for younger people to make a conversion to a Roth IRA than it is for older people?
Generally, the longer the money can be in the account growing tax-free the greater the tax benefit. However, older people may also benefit from Roth conversions – and conversions can be made regardless of age. Older people most likely to benefit are those who want to use the Roth IRA as a vehicle by which to pass along their wealth to heirs.
“There are a lot of personal variables in deciding on doing a Roth IRA conversion,” said Kaster. “Taxpayers considering a Roth IRA conversion would benefit from speaking with their tax advisors about the benefits specific to them, how much to convert and timing on paying the conversion taxes.”
About CCH, a Wolters Kluwer business
CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, accounting and audit information, software and services. It has served tax, accounting and business professionals since 1913. CCH is based in Riverwoods, Ill. Wolters Kluwer is a leading global information services and publishing company. Wolters Kluwer is headquartered in Alphen aan den Rijn, the Netherlands (www.wolterskluwer.com).
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