The Roth IRA conversion rules applicable for 2010 provide a tremendous opportunity to convert tax-deferred pension assets into tax-free Roth IRA assets.  This is the first year that everyone, regardless of income level, can convert a Traditional IRA into a Roth IRA, potentially providing large future tax benefits.

This article sets forth some fundamental information you should know about Roth conversions. It also addresses the most pertinent questions you should be asking to determine whether or not you would benefit from this opportunity.

Roth IRA Basics

The important distinctions between a Roth IRA and other retirement savings vehicles involve the current tax treatment of contributions and the future tax treatment of distributions. A Roth IRA is generally funded using after-tax dollars. These after-tax contributions and any earnings growth are exempt from tax upon distribution if the withdrawals are made at least five years after the account is established and after the owner is over age 59 ½. Original contributions made to the Roth IRA can be removed at any time without penalty.  Most other retirement savings plans, such as a Traditional IRA, are funded with pre-tax dollars. These accounts grow tax-deferred, and withdrawals are taxed at the taxpayer’s ordinary income tax rates at the time of distribution.

In a Roth conversion, one would roll over amounts from a Traditional IRA into a Roth IRA and generally pay income tax on the amount rolled over. Future asset growth in the Roth IRA would be tax-exempt.

Potential Benefits and Considerations of a Roth Conversion

Determining the benefits you may receive from a Roth conversion is a bit complicated, but if you answer yes to any of the following questions, you might be a good candidate for a conversion:

  • Do you anticipate being able to cover living expenses in retirement without using your IRA assets?

Beginning at age 70 ½, holders of assets in tax-deferred retirement accounts (Traditional IRA, 401(k), 403(b)) must take Required Minimum Distributions (RMDs) based on mortality tables provided by the IRS. Investors who would not otherwise need this money are forced to pay income tax each year on the distribution. Roth IRAs have no RMD requirement.

  • Do you have 10 or more years before you need to use retirement assets?

The longer the assets remain in the Roth IRA, the better, because it allows more time for money to compound tax-free.

  • Do you think that tax rates will be higher in the future than they are now?

Although many expect their total income to go down in retirement (and thus believe that they will fall into a lower marginal tax bracket), a growing consensus is that marginal tax rates will rise significantly. The higher income tax rates are in the future, the greater the benefit of a Roth conversion.

  • Do you have cash assets available outside of your retirement account?

The clearest benefits to the conversion come when one has funds available in non-retirement accounts that can be used to pay the income tax. Transferring all of the assets from a Traditional IRA to a Roth IRA will result in higher tax-free accumulations. Also, removing money from a Traditional IRA to pay taxes prior to age 59 ½ may result in an early distribution penalty of 10%.

  • Have you made nondeductible or after-tax contributions to a Traditional IRA or 401(k)?

If one has already paid tax on some of the assets included in a retirement account, then the taxable income recognized at the time of conversion will be reduced proportionately by the amount of those contributions.

A Roth IRA can also provide estate and inheritance advantages. Since RMDs are not required with Roth IRA assets, the entire balance of funds can pass tax-free to heirs. Heirs will be required to take annual distributions over their lifetimes, but the distributions and any asset growth over their lives will be tax-free.  With Traditional IRA assets, heirs are required to pay income tax as the funds are distributed over their lifetimes. For the deceased individual, the Roth IRA is included in his or her total estate but it is an asset that is net of tax whereas a Traditional IRA has an inflated pre-tax value, thus increasing the estate valuation.

Despite the advantages discussed above, this opportunity does not come without uncertainty or risks. It can be difficult to accurately calculate one’s income needs in retirement, let alone forecast future income tax rates.  Possible future tax law changes could also negatively change the income tax rate structure or impact the tax-free status of Roth IRAs.  Since you cannot be certain of what the tax rate picture will look like in the future, you could consider a strategy of partially converting Traditional IRA accounts so that your assets are spread among taxable, tax-deferred, and tax-exempt accounts. This strategy would allow you to strategically access funds to minimize taxable income each year.

Why You Should Consider a Roth Conversion Now

Roth conversions have been available since 1998, but 2010 is the first year in which individuals with an Adjusted Gross Income of more than $100,000 are allowed to participate. Additionally, the tax impact of conversions that take place in 2010 can be spread out over the 2011 and 2012 tax years if the taxpayer chooses.

If market conditions make a Roth conversion disadvantageous or you unexpectedly have additional taxable income during the year, you will have the opportunity to undo the conversion up until your tax return is submitted in April 2011 (or October 2011 if you file for an extension).  If you are considering a conversion up to a certain tax bracket, you can also choose to make a partial conversion of some of your assets as opposed to converting the entire account balance.

An Example of the Potential Savings

The following example illustrates the magnitude of the potential benefit for some individuals:


  • An individual, age 60, holds $150,000 in a Traditional Rollover IRA that was funded from a former employer’s 401(k) retirement savings account. Assume current and future income tax rates of 33% and a growth rate of 8% in both the Traditional and Roth IRAs.  Assuming that this individual lived until age 87, the RMDs from the Traditional IRA would total $412,330, and the tax paid on those RMDs would amount to $136,069, leaving an account balance at death of $511,088 to pass to heirs. Were the assets converted to a Roth IRA, under the same scenario, the individual would save the $136,069 in taxes because RMDs are not required and would have an account balance of $1,294,066 (more than double the Traditional IRA amount) at death to pass to heirs.

We realize that conversions are complicated and make sense only for certain taxpayers. With so many variables to consider, if you are considering a Roth conversion, please contact us for a consultation.

This newsletter is for informational purposes only. It should not be constituted as tax, legal, or investment advice. Information has been gathered from sources believed to be reliable, but individual situations can vary and you should consult with your investment, accounting and/or tax professional.