Roth conversion could be for you

January 2010 ushered in major changes in tax laws governing individual retirement accounts (IRAs) – changes that some commentators believe create unprecedented financial-planning opportunities.

Prior to 2010, eligibility to convert a traditional IRA to a Roth IRA was subject to strict income limitations. Now, under current law, Roth conversions are available to people of all ages and income levels.

Basics of Roth IRAs

Like traditional IRAs, Roth IRAs provide a tax-efficient investment vehicle for retirement funds. However, unlike contributions to traditional IRAs or 401(k) plans, contributions to Roth IRAs are not tax-deferred. Amounts contributed to a Roth IRA are not deductible from gross income; once the initial tax is paid, however, the assets in a Roth IRA will grow tax-free. Qualified distributions from the account will also be tax-free. For qualified distributions, the accumulated earnings are never subject to tax.

Another attractive feature of Roth IRAs is that the account owner does not have to take required minimum distributions (RMDs) during his or her lifetime, as would be required of traditional IRA owners who have reached age 70½. In other words, the Roth IRA owner does not have to withdraw a minimum amount from his or her Roth IRA each year after reaching a certain age, and the assets can continue to grow and compound tax-free. Roth IRAs are subject to RMDs after the death of the account owner, but such distributions to heirs will also be tax-free.

Tax and Estate Planning Implications of Roth Conversions

When a traditional IRA is converted to a Roth IRA, the entire conversion amount is subject to income tax as if it were a distribution from the IRA. Depending on the value of the account, this income tax burden could be significant. However, if the account owner is able to offset this taxable income through the use of charitable deductions, net operating losses, individual tax credits and other tax means, then a Roth conversion could be an excellent tax-planning strategy.

While young, high-wage earners who can allow their Roth IRA assets to grow tax-free for a long period of time are great candidates for Roth conversions, Roth conversions provide an advantageous tax-planning and estate-planning tool for people of all ages. The effectiveness of a Roth conversion is enhanced if the account owner is able to use “outside” (non-qualified) assets to pay the conversion tax and, thus, keep as much money as possible growing in the Roth IRA. A conversion is further enhanced if the account owner does not need to use the assets for future living expenses and can allow the maximum amount of Roth assets to pass to the next generation.

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By converting a traditional IRA to a Roth IRA, the account owner can leave assets to his or her heirs that will not have an inherent income tax liability. That means that when the heirs take distributions from the Roth IRA, they will not pay income tax. A Roth conversion can also be an effective estate-planning tool for an individual who anticipates having a taxable estate because the conversion enables the payment of income tax with assets from the estate, thereby reducing the eventual estate tax burden.

Recharacterization

Of course, there are risks associated with forgoing the tax-deferred status of IRA assets and accelerating the tax due. One risk of conversion – especially pertinent in the world of market volatility in which we currently live – is that an account balance will plummet after conversion. For example, if a $500,000 traditional IRA is converted in July of 2010 and by November of that year, the Roth IRA is worth only $400,000, the account owner will still have to pay tax on the full $500,000. In this example, there would be an income tax liability on $100,000 worth of value that eroded.

Thankfully, there is a mechanism to “undo” a conversion that is not successful — recharacterization. A recharacterization is tantamount to treating the transaction as if the Roth conversion never occurred — the retirement assets are returned to the traditional IRA and the payment of the conversion tax is avoided. There are tax reporting obligations and certain limitations on the timing of a recharacterization, so make sure to consult a tax advisor to ensure that the applicable requirements are satisfied.

If At First You Don’t Succeed…

If an underperforming IRA conversion prompted a recharacterization of the initial conversion, there still might be a chance for a second bite at the apple. An IRA owner is permitted to make another conversion of the same traditional IRA assets to Roth IRA assets on the later of (1) the tax year following the original conversion, or (2) 30 days after the recharacterization.

Explore the Possibility

The decision about whether to convert (or to recharacterize or reconvert, for that matter!) is a complex one that must take into account many factors. If you would like to employ some of the retirement-planning strategies discussed in this article, Roth conversion might by an opportunity worth exploring.

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Sarah Marks is an attorney with the Private Client Group at Holland & Hart LLP and focuses her practice in wealth transfer, tax and estate planning, and charitable giving. She also has experience practicing in the area of employee benefits, ERISA, and executive compensation. Sarah can be reached at 303-295-8470 or [email protected].