Roth IRA rollover presents challenges and opportunities

November 14, 2009
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The approach of the year’s end brings more challenges than where to get a deer-hunting license or the search for the perfect gift. For many taxpayers, the end of the year presents opportunities to roll over amounts in qualified employer-sponsored retirement plan accounts (including 401(k)’s and profit-sharing plans) and regular IRA’s into Roth IRAs. 

But there are some limitations — and there also may be reasons to wait until 2010 to make that rollover.

Before delving into the twists and turns of rollover planning, let’s first identify the Roth IRA’s attractive qualities that would compel an individual to consider a rollover:

  • As with a regular qualified employer plan or IRA, earnings within a Roth IRA are tax-sheltered.

  • Withdrawals from a Roth IRA aren’t taxed if: a) the account holder is at least 59½ years old or meets specific exceptions set by the IRS; and b) the withdrawn funds were in the account for at least five years.

  • The Roth IRA owner isn’t required to begin lifetime minimum distributions at age 70½.

  • Beneficiaries of Roth IRAs receive tax-sheltered earnings and tax-free withdrawals. However, they do have to commence regular withdrawals from a Roth IRA after the original account owner dies.

There’s one big catch to a Roth rollover, which can be a deal-breaker: The rollover will be fully taxed, assuming it is made with pre-tax dollars and the earnings on those pre-tax dollars. (Roth rollover owners should try to pay those taxes from a source other than the IRA.)

In dealing with a topic that doesn’t always follow logic, the easiest way to make sense of the rules is to initially identify them chronologically.

Prior to Jan.1, 2008:
Those wishing to convert 40(k)’s, Simple IRAs, SEP IRAs, 403(b)’s, 457’s and qualified pension plans into Roth IRAs had to complete a two-step process. Step one: Open a Traditional IRA. Step two: Convert the Traditional IRA into a Roth IRA. These opportunities applied only to those with an adjusted gross income of less than $100,000.

Although the laws provided for the above rollovers into Roth IRAs, the ultimate determiner of whether it could be done was left to the discretion of the earlier plan’s administrator. Many 401(k)’s and 403(b)’s limited rollovers to traditional IRAs, and necessitated the two-step process.

Jan.1, 2008-Dec. 31, 2009:
The rollover option continues to be limited to individuals with an adjusted gross income of $100,000 or less.

Post Jan. 1, 2010:
The first change to arrive with the New Year for Roth rollovers is the repeal of the AGI cap of $100,000. In 2010, anybody will be able to convert traditional IRAs and retirement plans to a Roth IRA, regardless of income level. 

Roth rollovers made after the first of next year also present both a one-time choice and a challenge: Taxes due on Roth IRA rollovers made in 2010 may be payable half in 2011 and half in 2012, unless the person making the rollover elects to pay the entire tax bill in 2010.

At first encounter, one might wonder why anyone would opt to pay full freight in 2010. But (and make that a big BUT), if current tax laws remain in effect, tax brackets above the 15 percent bracket revert to their pre-2001 levels in 2011. That translates to higher tax rates, by three or more percentage points. Current political circumstances make it difficult to determine exactly who will be affected by the higher taxation rates. Individuals with higher levels of income may want to consider paying the tax on the Roth rollover in 2010.

Additional considerations
There are some long-term prospective benefits to a Roth IRA rollover, all dependent on circumstances but deserving study:

Some individuals actually do have more money than they need in retirement, so a required distribution at age 70½ isn’t desirable. Because a Roth IRA doesn’t mandate distributions, the vehicle is given the opportunity to compound at a greater rate than an IRA, until the distributions are taken. That can mean more income for the Roth IRA owner’s later years — and/or more for their heirs.

Because the Roth IRA only contains after-tax dollars, the effective amount of the Roth IRA is greater than a traditional IRA. Conversely, with a traditional IRA or 401(k), the better the investment performance, the more taxes paid by the owner. That’s not true for a Roth IRA.

For those who expect to have a significant amount remaining in their retirement plan when they die, the Roth IRA conversion may mean the owner’s heirs will avoid having to pay a higher tax rate on that portion of their inheritance than if it were in a traditional IRA, 401(k), or other retirement plan.

Distributions from a Roth IRA are not counted as “tax-exempt income” that is included in the calculation of social security benefit taxation. The conversion to a Roth IRA can even reduce potential tax liabilities on Social Security benefits.

In anticipation of the above described changes in tax law and tax rates, there are a number of ways that individuals can prepare for the changes and the opportunity they afford. Non-high-income individuals (under the $100,000 threshold) should make deductible IRA contributions this year. That action will reduce the 2009 tax bill, and for those who wait until 2010 to convert to a Roth IRA, taxes can be deferred until 2011 and 2012. Those who have never opened a traditional IRA should consider doing so this year and make the biggest allowable nondeductible contribution that is affordable. Some high-income individuals ($100,000 plus) should consider ways to defer their deductions to 2010 and accelerate income from 2010 into this year.

Whatever the circumstances, the rollover decision and its timing need to reflect comprehensive and careful consideration of a family’s entire financial situation. Detailed  planning now can mean more dollars down the road for retirement or heirs. These concerns should be addressed with knowledgeable advisors well in advance of Dec. 31.

Julie M. Ridenour is director of business development, Norris, Perné & French LLP.

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