ECONOMIC OUTLOOK

Preparing for the 2010 IRA-to-Roth IRA conversion opportunity

Editor’s note: Joe M. Arnett is the partner in charge of tax services and information technology for Deloitte & Touche in Guam and Micronesia, a position he has held for the past 22 years. Prior that, he spent six years working for the U.S. Internal Revenue Service, three years as the tax director for the cable television subsidiary of Time Inc., and was international tax director and risk management director for Computer Automation Inc. He is an active member of the Guam Chamber of Commerce, and serves on its board of directors, on its executive committee as secretary/treasurer and on the steering committee of the chamber’s Armed Forces Committee. Arnett has a bachelor’s in accounting from Ball State University and an MBA in finance from the University of Colorado.

With the new year is a significant opportunity for many individuals with Individual Retirement Accounts. Beginning in 2010, taxpayers will be able to convert his or her traditional IRA (and funds that have been rolled over from a qualified plan) to a Roth IRA, regardless of his or her income level or filing status. What’s more, the tax on the taxable income generated from a 2010 conversion will be able to be deferred until 2011 and 2012. This new conversion option presents both tax planning opportunities and challenges for 2009, 2010 and 2011. Before 2010, only individuals with modified adjusted gross incomes of $100,000 or less could convert amounts in their traditional IRA to a Roth IRA. Moreover, married taxpayers filing separate returns have also been prohibited from converting a traditional IRA to a Roth IRA as well. However, beginning in 2010, the $100,000 adjusted gross income limit on conversions of traditional IRAs to Roth IRAs is eliminated completely. This special treatment gives everyone, regardless of his or her income level, the opportunity to convert a traditional IRA to a Roth IRA. Additionally, filing status restrictions are also lifted, allowing married taxpayers filing a separate return to convert a traditional IRA to a Roth IRA. It is important to understand that an IRA conversion is treated as a taxable distribution, taxed as ordinary income at your marginal tax rate. This in effect accelerates the taxable income that you would eventually pay on distributions from a traditional IRA once you retire, but does so in exchange for never taxing any future appreciation in the value of your account from what it is today. That is often a significant tax advantage. You should also note that unlike a withdrawal from an IRA, a conversion does not trigger a 10% early withdrawal penalty. Although conversion to a Roth IRA does trigger immediate taxable income, Congress provided a special incentive in 2010 to jumpstart Roth conversions under the new rules: In 2010 (and 2010 only), individuals will have the choice of recognizing their conversion income in 2010 or averaging it over 2011 and 2012. You must elect one option. This allows you to pay taxes on the converted amount ratably over two years, instead of recognizing it all as income in one year. You will be taxed at the rates in effect for 2011 and 2012. For some taxpayers, their tax rate may rise after 2010 even if their income does not. President Obama has proposed, and Congress is expected to enact, legislation to restore the top two pre-2001 marginal income tax rates after 2010. This means that the top two brackets will be 39.6% and 36% after 2010. Consequently, if you do not want to take the chance that your income tax rate will be higher in 2011 and 2012 than in 2010, you may want to elect to pay the full tax on the Roth conversion in your 2010 income tax return, at 2010 income tax rates. Taxpayers are expected to convert their traditional IRAs to Roth IRAs for a variety of reasons. Roth IRAs have two major advantages over traditional IRAs. First, Roth IRA distributions are tax-free if they are qualified distributions. To be qualified, they must be made after a five-year holding period has passed and after the accountholder reaches age 59-and-a-half, or on account of death, disability or the qualified purchase of a first home.

Second, Roth IRAs are not subject to the required minimum distribution rules that apply to traditional IRAs (as well as individual qualified plans). Therefore, a Roth IRA accountholder who reaches age 70-and-a-half does not need to begin taking distributions; instead, the funds can continue to grow tax-free until they are needed or are passed on to heirs.

The tax-free nature of qualified Roth IRA distributions may prevent individuals from being taxed in a higher tax bracket that would otherwise apply if he or she were withdrawing taxable distributions from a traditional IRA. Moreover, these distributions — unlike those from traditional IRAs — do not affect the calculation of tax owed on Social Security payments and do not affect adjusted gross income-based deductions. The conversion to a Roth IRA is not limited to traditional IRAs. It is also allowed from other types of individual retirement accounts, such as SEP IRAs or SIMPLE IRAs, provided certain requirements are met. However, be aware that once a SEP IRA or a SIMPLE IRA is converted to a Roth IRA, future contributions under the plan cannot be made to the Roth IRA account. An IRA to Roth IRA conversion should be considered by individuals who:

• Can afford the tax on the converted amounts;
• Anticipate being in a higher tax bracket in the future than they are currently in; and
• Have a significant amount of time before reaching retirement to allow assets to grow tax-free and recoup dollars that may have been lost due to the conversion tax.
  

If you are planning on taking advantage of the Roth IRA conversion opportunity in 2010, consider the following strategies.
Because of the economic slowdown, many individuals are postponing retirement. Roth IRAs, unlike traditional IRAs, generally have no age limitation on contributions from earned income or on mandatory payouts. This is an advantage for individuals who are extending their careers beyond traditional retirement age.

If you are able to make deductible IRA contributions for 2009, do so. This can help you reduce your 2009 tax bill and, if you convert to a Roth IRA in 2010, you will not have to pay back the tax savings until 2011 and 2012, if you elect to ratably pay the tax over the two-year period. Additionally, you may want to consider making nondeductible IRA contributions for 2009 since you can later roll over the amounts into Roth IRAs in 2010 at no tax cost.

If you anticipated being below the $100,000 adjusted gross income level for 2009 and already converted to a Roth IRA while your traditional IRA account balance is still low because of stock market declines and your situation is different from what you anticipated before you file your 2009 return, you can still “recharacterize” your 2009 Roth conversion back to a traditional IRA and then convert to a Roth IRA in 2010 instead. Note: For 2010, the adjusted gross income limits for maximum Roth IRA contributions is $167,000 for married joint filers (up from $166,000 in 2009), and will remain at $105,000 for other filing statuses, including married individuals filing separately and single taxpayers. While the $100,000 AGI limit for rollovers has been lifted, the AGI limit for annual contributions has remained. There are a significant number of tax and financial considerations that come into play when determining whether to convert your traditional IRA to a Roth. Taking advantage of the easing of the rules in 2010 may make this the perfect time to convert a traditional IRA account to a Roth. If you have any questions about traditional IRA to Roth IRA conversions and the new 2010 planning opportunity, your tax advisor can provide more information and should be consulted before any action is taken. The Essential Tax and Wealth Planning Guide for 2010, published by the Private Client Advisors group of Deloitte, provides concrete information and planning tips that can help you manage your wealth year-round is available at www.deloitte.com.