Time to bid adieu to the Roth IRA conversion cap

Filed under: Banking & Finance |

Changes during 2010 will allow more people than ever to convert from a traditional Individual Retirement Account to a Roth IRA.

The beauties of Roth IRAs are multiple: After-tax dollars are contributed, growth is tax-free, they don’t have required minimum distributions and, because distributions are not taxable, they don’t affect taxation of Social Security benefits.

There are three ways to obtain a Roth IRA: Individuals who qualify may contribute money to a Roth each year, or they can convert a traditional IRA to a Roth or they can inherit a Roth IRA.

More than 11 million households will be eligible for a Roth IRA conversion during 2010. This includes about $1.2 trillion in previously unconvertible traditional IRA assets, and another $1 trillion in potentially convertible 403 (b) and Keogh accounts.

During 2009, the conversion limit for Roth IRAs is $100,000 modified adjusted gross income — for single and joint tax returns. But beginning Jan. 1, the income limit will be lifted.

Whether to convert can be answered with a general rule.

“If — when you retire — you’ll be in a higher tax bracket, then you should probably convert,” Eric Ryan, partner with Stockman, Kast Ryan & Co. LLC, told the audience during a recent SKR seminar. “But, if you’re at the height of your career now, and you’ll be in a lower tax bracket when you retire, conversion might not be as beneficial.”

And for Generations X, Y and I-don’t-do-face-to-face-you-can-Facebook-text-or-IM-me — this might well be the time.

“For young people, it’s a no-brainer to convert — or at least to contribute to a Roth IRA,” said Bernie Benyak, tax manager with SKR.

And remember that conversions don’t have to be done during 2010.

However, many people believe that income taxes will increase, so some will choose to convert sooner rather than later.

The Revenue Act of 1964 dropped the maximum rate to 77 percent during 1964, and to 70 percent during 1965. The Tax Reform Act of 1986 further dropped the maximum rate to 38.5 percent during 1987, and 28 percent during 1988. Currently, the maximum tax rate is 35 percent.

Read between the lines. Tax rates are close to historical lows, so they can only go one direction — up.

The Tax Increase Prevention and Reconciliation Act of 2005, signed by President George W. Bush on May 17, 2006, introduced tax deferral for 2010 conversions.

For 2010 conversions only, taxpayers can report all the income from the conversion on their 2010 tax return, or report 50 percent of it during 2011 and the remaining 50 percent during 2012.

This flexibility gives taxpayers until Oct. 15, 2011 (the extended due date) to decide when to pay the tax.

If taxpayers will have a large 2010 loss from an S corporation or partnership, “we can report the conversion income on the 2010 tax return — to net against that loss,” Benyak said. “But if 2010 is a humungous income year — you probably don’t want to add your conversion income to your 2010 tax return.”

And for those who are already judiciously carving out an estate plan — the disappearing modified AGI cap might seem like the parting of the Red Sea.

“If I inherit a Roth IRA, I have to take money out (annually) over my expected lifetime, according to a mortality table, but there’s still no income tax,” Ryan said. “Don’t underestimate the benefit of leaving your kids a Roth IRA. This money will keep on growing and growing tax-free while your kids take out the required minimum distribution.”

For investors and consumers considering a conversion, pay the conversion income taxes with non-Roth IRA money.

“You’re creating a great benefit for your lifetime by converting — don’t cheat yourself by paying taxes with Roth IRA money,” Ryan said.

Children/adult children — hand this column to your parents to read.

Parents — listen to Ryan’s advice.

“If you’re extremely wealthy and don’t need your IRA for retirement, you could convert to a Roth, pay the tax now, and let your kids have that money grow tax-free for their whole lives,” Ryan said. “You’re basically prepaying income tax for yourself and your kids. It’s a smart estate planning strategy — if you don’t need the money yourself during retirement.”

Rebecca Tonn covers banking and finance for the Colorado Springs Business Journal.