Estate Planning: Are You Ready To Roth?
November 2009
Are You Ready To Roth?
Are you thinking about converting your IRA to a Roth IRA in 2010? You are not alone. 2010 is the first year that you will be able to convert a traditional IRA or qualified plan account into a Roth IRA even if your adjusted gross income is over $100,000.
As a consequence, Roth IRAs are a hot topic. Many financial planning pundits are touting the marvels of Roth IRAs. Roth IRAs do offer some unique benefits, but a decision to convert to a Roth IRA should not be based on media hype.
How do you know if a Roth IRA conversion is right for you? Are you ready to pay the tax on the conversion? Do you know when withdrawals from Roth IRAs are tax-free? These are just some of the questions that you need answers to before you are really ready to Roth.
To get you started on answering those questions, this Alert summarizes:
- How a traditional IRA or qualified plan account is converted into a Roth IRA
- How conversion contributions to Roth IRAs are taxed
- How Roth IRA distributions are taxed
- How a Roth IRA is distributed after death?
Of course, this general discussion of law and planning concepts should not be taken as legal advice or as a specific recommendation. You should consult with your estate planning attorney and other professional advisers to determine whether in light of your individual circumstances a Roth IRA conversion is the right strategy for you.
How is an IRA or Plan Account Converted to a Roth IRA?
Carefully. As with any financial transaction, be sure that accurate written instructions are provided; ask for written confirmation of the transaction; monitor your account statements to be sure that the transaction is correctly reflected on those statements; and make sure that the beneficiary designation on the account is completed and is consistent with your planning.
If your adjusted gross income is $100,000 or more (or if you are married filing separately), do not attempt a Roth IRA conversion until 2010.
A traditional IRA can be converted to a Roth IRA by any of three methods:
- An amount is distributed from the traditional IRA and contributed to a Roth IRA not later than the 60th day after the date of the distribution.
- An amount in a traditional IRA is transferred in a trustee-to-trustee transfer from the trustee or custodian of the traditional IRA to the trustee or custodian of the Roth IRA.
- An amount in a traditional IRA is transferred to a Roth IRA maintained by the same trustee or custodian. In effect, the current trustee or custodian redesignates your traditional IRA as a Roth IRA.
If the transaction is not correctly executed, you could find yourself with a very large tax and penalty bill without the benefit of a tax-free account! Be certain that your traditional IRA is timely rolled, or transferred, or redesignated as a Roth IRA.
These rules talk about converting a traditional IRA to a Roth IRA, but it is also possible to convert a qualified retirement plan account, such as a 401(k) plan account, into a Roth IRA. As a practical matter, however, most conversions will be from a traditional IRA into a Roth IRA because most qualified retirement plans do not allow distributions while you are still employed. Check with your employer or plan administrator to see if this option is available to you.
SIMPLE IRAs and SEP IRAs can also be converted via a rollover to Roth IRAs, but a special holding period applies to contributions to SIMPLE IRAs, so you may not be able to convert the entire account.
There is no requirement to convert the entire traditional IRA or qualified plan account into a Roth IRA. In some cases, a partial conversion may be strategic. Some clients may choose to convert half of their traditional IRAs to Roth IRAs to hedge against the impact of future increases or decreases in income tax rates. (See Why All the Talk About Roth IRAs? for a discussion of the effect of tax rates on the Roth IRA conversion analysis.)
If you have made nondeductible contributions to your IRA or qualified plan accounts, those amounts will not be taxed upon conversion to a Roth IRA, so this can be a very efficient way to convert to a Roth IRA. Note, however, that there are complex rules that determine how nondeductible contributions to traditional IRAs or qualified plan accounts can be distributed, and the rules are different for traditional IRAs and qualified plans, so you should consult a tax professional before planning to convert nondeductible contributions in a traditional IRA or qualified plan into a Roth IRA.
The income limitations on making regular, annual contributions to Roth IRAs remain in effect in 2010 and later years. It is only the $100,000 adjusted gross income limit and the filing status limitation for Roth IRA conversions that are being removed for 2010 and later years. Many clients with substantial incomes (e.g., joint filers with income of $187,000 or more in 2010) will not be eligible to make annual contributions to Roth IRAs, even though they will be eligible to convert existing, traditional IRAs into Roth IRAs.
Income limits also apply to restrict deductible annual contributions to traditional IRAs if you are participating in a qualified plan, but those limits do not apply to nondeductible contributions to traditional IRAs. As a consequence, some clients may make a nondeductible contribution to a traditional IRA in 2009 that is converted to a Roth IRA in 2010. If the law does not change, this process could be repeated each year to build up a Roth IRA.
Again, this planning should be done in consultation with your tax advisors. It will be necessary, for example, to consider the rules regarding the distribution of nondeductible contributions, holding periods, and the complexities of maintaining multiple accounts.
How Are Conversions Taxed?
Amounts converted from a traditional IRA or qualified plan account are treated as though distributed from the traditional IRA, even if the conversion occurs by way of a trustee-to-trustee transfer or a redesignation of an existing account.
The IRA trustee or custodian will report the amount of that distribution as a distribution of ordinary income, and you will pay tax at ordinary income rates on the amount of that distribution in the year of conversion. However, if you are converting to a Roth IRA in 2010, the income from that distribution and conversion will be prorated between the years 2011 and 2012, unless you elect to have all of the income included in the year 2010.
Many clients believe that their effective tax rates are likely to increase in future years, so they are planning to forego the two-year income tax deferral that is available for conversions in 2010. Instead, they plan to include all of the income on their 2010 return. Amounts converted in years after 2010 will be taxed in the year of the conversion.
Ordinarily, distributions from traditional IRAs or qualified plan accounts before age 59-½ are subject to an additional 10% tax. However, a special rule applies to Roth IRA conversions. The 10% additional tax does not apply to a conversion of a traditional IRA or qualified plan account to a Roth IRA. However, if you are under age 59-½ at the time that you convert to a Roth IRA, any distributions from the Roth IRA during the five years following the date of the conversion will be subject to the 10% additional tax, unless an exception to that additional tax otherwise applies. This five-year period applies to every conversion. Note, this five-year conversion period is distinct from the five-year non-exclusion period that is described in the next section.
Anticipating the big tax bill that comes with a Roth IRA conversion, many clients will look to maximize ordinary income tax deductions in 2010. Consider whether you have deductions that can be postponed or carried over into 2010, or whether you can accelerate deductions into 2010. For example, if you are contemplating a major charitable gift, it may be efficient to make that gift in the year that you will be taxed on your Roth IRA conversion.
What happens if you change your mind? You have until the due date of your tax return for the year of the conversion to change your mind and undo the conversion - this is called a “recharacterization.” If you transfer all the amounts that you intended to convert (and earnings on those amounts) back into a traditional IRA by the due date of your tax return, then the conversion is undone. This needs to be carefully documented and reported, so you should consult your tax advisors in connection with any recharacterization. [Change your mind again? You can “reconvert” the amounts that you recharacterized, but you need to wait for the next year, or at least 30 days following the recharacterization.]
A recharacterization can be especially helpful if the amount that you converted loses substantial value from the date of the conversion to the tax return due date. In that case, you probably want to recharacterize the Roth IRA back to a traditional IRA so you are not paying tax on assets you no longer own. If you convert a traditional IRA in January of 2010, for example, you could wait until October of 2011 to make a decision about reclassifying the Roth IRA, assuming your tax return is on extension. You cannot choose to recharacterize only those investments that have gone down in value. If you choose to recharacterize only a portion of the amount originally converted, the recharacterization will apply proportionately to all the assets originally converted.
How Are Roth IRA Distributions Taxed?
A distribution from a Roth IRA is not includable in your gross income if it is a qualified distribution or to the extent that it is a return of your contributions to the Roth IRA. This is the real attraction of the Roth. You pay tax on amounts contributed to a Roth IRA, but once there, your future earnings and distributions will be tax-free as long as you satisfy the qualified distribution requirements. In most cases, it will be very easy to satisfy these requirements. A “qualified distribution” is a distribution that is both:
- made after the five-year non-exclusion period; and
- made on or after the date on which you attain age 59-½ (or is made to a beneficiary after your death, is attributable to your being disabled, or is made under an exception for first time home buyers).
Withdrawals of
contributions to Roth IRAs (including conversion contributions) are not subject to regular income tax. The 10% additional tax may apply if the contribution being withdrawn is from an amount that you converted from a traditional IRA or a qualified plan account before age 59-½ (unless you satisfy the five-year conversion period described below, you are over age 59-½, or another exception applies).
Withdrawals of
earnings are subject to the regular income tax and the 10% additional tax unless the earnings are withdrawn in a qualified distribution. In other words, you cannot make tax-free withdraw of earnings from your Roth IRA until the five-year non-exclusion period has been satisfied
and you have attained age 59-½ or one of the other conditions of a qualified distribution is satisfied.
To put this positively, if you are over age 59-½, then after the five-year non-exclusion period is satisfied, all amounts distributed from the Roth IRA to you or your beneficiaries for the rest or your life or their lives will be income tax-free.
How do you know if you are withdrawing regular contributions, conversion contributions, or earnings from your Roth IRA? The Treasury Department has given us clear and favorable rules in this area. The first dollars distributed are deemed to come from regular, annual contributions. Once those have been exhausted, the next dollars distributed are conversion contributions. Lastly, after all contributions have been distributed, remaining withdrawals are deemed to consist of earnings.
Obviously, Roth IRAs are very different from traditional IRAs in many ways, but Roth IRAs are still IRAs and must follow the general rules that apply to IRAs. For example, as with traditional IRAs, to preserve the favorable tax treatment and avoid penalty, owners of Roth IRAs must avoid investing in certain kinds of assets or engaging in prohibited transactions with Roth IRA assets.
How Is a Roth IRA Distributed After Death?
Much of the excitement surrounding Roth IRA conversions stems from the long-term estate planning possibilities with Roth IRAs. For example, if you are fortunate enough to have an IRA or qualified plan account that you will not need to fund your own retirement, then you can convert that account to a Roth IRA, allow the account to grow tax-free for your lifetime and, possibly, your spouse’s lifetime without taking withdrawals, then the account can pass to your children who can take tax-free distributions from the account for their lifetimes.
The benefits of this strategy are magnified if you are able to pay the tax on the Roth IRA conversion with the assets of the traditional IRA or qualified plan account that you convert. (
See our previous Alert entitled Why All the Talk About Roth IRAs? for a discussion of the factors that can result in a Roth IRA significantly outperforming a traditional IRA or qualified plan account.)
At a Roth IRA’s owner’s death, minimum required distributions to beneficiaries are determined as though the Roth IRA owner died before obtaining age 70-½. Therefore, the account must be distributed either by the end of the fifth year containing the anniversary of the owner’s death or over the life expectancy of a designated beneficiary. If the spouse is the sole beneficiary, he or she can postpone required distributions until the deceased owner would have attained age 70-½, or the spouse can treat the Roth IRA as his or her own, or roll the Roth IRA into his or her own Roth IRA, thereby postponing required distributions to his or her death.
The minimum distribution rules apply separately to Roth IRAs and traditional IRAs. For example, amounts taken from the traditional IRA by a beneficiary do not offset the amount of a required distribution from an inherited Roth IRA. Separate Roth IRAs can be set-up for multiple beneficiaries. Each beneficiary will receive a prorated portion of the deceased account owner’s contributions, rollover contributions and earnings.
Of course, any plan to pass assets down to your beneficiaries should be carefully integrated into your overall estate plan. This Alert has focused on income tax aspects of Roth IRA conversions and distributions, but there are estate tax and generation skipping tax issues to consider. Consult with your estate planning attorney to discuss how to integrate a Roth IRA into your estate plan.
The Five-Year Rules
The great attraction of Roth IRAs is the fact that withdrawals from Roth IRAs can be tax-free. There are situations where withdrawals from Roth IRAs will be taxed, but it will not be difficult in the great majority of cases to qualify withdrawals for tax free treatment.
For example, if you are over 59-½ now, or if you will be over 59-½ before the end of five years, starting in the year you first contribute to or convert to a Roth IRA, and you do not withdraw any amounts from the Roth IRA during that five-year period, then your withdrawals will be tax-free, and you can skip the rest of this Alert that describes the complex five-year rules that may apply to make some withdrawals taxable.
The Five-Year Non-Exclusion Period. The five-year non-exclusion period begins on the earlier of the first day of the calendar year for which you make your first regular contribution to a Roth IRA, or the first day of the calendar in which you first make a conversion contribution to a Roth IRA. This five-year period ends on the last day of the fifth consecutive year beginning with the year for which you made the first Roth IRA contribution of any kind. For example, if you make a Roth IRA contribution for the year 2009, the five-year non-exclusion period would start on January 1, 2009 and terminate at the end of the year 2013. (This period is computed differently for designated Roth accounts in qualified plans. This Alert does not address those types of accounts.)
You need to satisfy the five-year non-exclusion period only once in your lifetime. If you made a Roth IRA contribution in 2005, for example, then you will have satisfied the five-year non-exclusion period by the end of 2009. In this example, you could, starting in 2010, withdraw any earnings tax-free, and all earnings on future contributions could be withdrawn tax-free, provided you are over 59-½ or one of the other conditions of a qualified distribution is satisfied at the time of the withdraw.
If you die before the expiration of the five-year non-exclusion period, your beneficiary, whether a spouse or non-spouse, will step into your shoes for purposes of measuring the five-year non-exclusion period. Note, if a surviving spouse elects to treat the Roth IRA as his or her own Roth IRA or if he or she rolls it into a Roth IRA in his or her own name, in addition to satisfying his or her own five-year non-exclusion period, the spouse must be over age 59-½ (or one of the other conditions must be satisfied) to receive tax-free distributions.
The Five-Year Conversion Period. As mentioned above, a separate five-year period starts with every conversion to a Roth IRA. This five-year period is not related to the five-year non-exclusion period. This five-year period, called the “five-year conversion period” in this Alert, concerns the additional 10% income tax. When a qualified plan account or traditional IRA is converted to a Roth IRA, the assets in those accounts are subject to income tax in the year of the conversion, but the 10% additional tax does not apply even if you are under age 59-½ at the time of the conversion. However, if the conversion amount is withdrawn from the Roth IRA within five-years of the conversion, the 10% additional tax will apply to that conversion amount (not just the earnings), unless an exception to the 10% penalty applies (e.g., you are over age 59-½ at the time of that withdrawal).
Again, this five-year conversion period is different from the five-year non-exclusion period. This period applies from the date of any conversion, so you may be subject to more than one five-year conversion period, but you will only be subject to one five-year non-exclusion period.
If you would like to analyze whether a Roth IRA conversion should be a part of your retirement or estate planning, please contact one of our employee benefits attorneys or your estate planning attorney.
Michael G. Riley at 216.348.5454 or mriley@mcdonaldhopkins.com
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