The rules for the Roth IRA are changing on Jan. 1, and the calls already are starting to flood into local financial advisers from confused clients.
The first question many are asking: Should I convert my regular IRA into a Roth IRA in 2010?
Beginning next month, people and households that earn more than $100,000 annually will be eligible to make that conversion for the first time.
There are benefits to making the switch. Unlike with a traditional IRA, retirees are able to withdraw earnings from a Roth IRA tax free, and they are not required to take minimum distributions annually after age 70 1/2.
But the decision is not that easy to make. Local financial advisers say there are downsides to switching from a regular IRA to a Roth account, namely paying taxes upfront. Money converted from a regular IRA will be treated as taxable income.
“Just because the rules have changed doesn’t mean you should be doing this,” says Betsey Purinton, president of the Financial Planning Association of Rhode Island and vice president at the Providence investment advisory firm StrategicPoint. “There definitely should be some discussion about it. You have to do your due diligence.”
The change to the Roth IRA conversion rules was actually approved by Congress several years ago as part of the Tax Increase Prevention and Reconciliation Act of 2005, which among other things removed the modified adjusted gross income limitation on Roth conversions as of Jan. 1.
For the first time, it opens the door for those who have gross income above $100,000 annually to convert some or all of their IRAs.
Most financial experts say the government cleared the way for high-wage earners because it desperately needs the tax revenue such conversions would generate now, as opposed to deferring those tax payments until after retirement.
By switching to a Roth IRA, individuals “are essentially prepaying their taxes,” says Brian Hickox, a financial adviser with the Providence investment firm Brown, Lisle/Cummings Inc. “The government’s mindset was a dollar in the hand today was worth $2 tomorrow.”
First, there are the upfront costs.
If a taxpayer were to convert $100,000, for example, that move could add as much as $35,000 in taxes onto their 2010 return, depending on that person’s income tax bracket.
But most financial advisers say anyone considering a conversion should not take money out of their IRAs to cover the taxes.
The reason is two-fold: Using IRA money diminishes a person’s retirement savings and reduces the future earnings on those IRAs. Also, if the person making the conversion is under 59-and-a-half, he or she faces a 10 percent early-withdrawal penalty on the amount used for taxes.
“That’s one of the questions that should be asked: Can you afford to do it?” Purinton says. “You don’t want to take money out that’s going to grow tax-free.”
Individuals should also consider whether they’ll have to rely on the IRA distributions in retirement and whether their goal is to leave behind a sizable inheritance, according to Rick Petrucci, estate and business planning attorney at Oceanstate Financial Services in East Providence.
“Because you don’t have to take the IRA distribution [with a Roth IRA], it’s a very nice way to transfer wealth that will be tax free on to your children or other relatives,” he says.
Age, too, should be a deciding factor, says Peri Ann Aptaker, director of wealth management at Providence-based Kahn, Litwin, Renza & Co. Ltd.
The younger the person considering the conversion, the longer the Roth IRA will have to build, the more likely the switch is to be beneficial, Aptaker said.
Deciding whether a conversion is appropriate requires predictions for the future, many say.
For IRAs that are converted in 2010, the government will allow a choice: Individuals can either report the conversion on their 2010 return, or spread it 50-50 over 2011 and 2012.
For those who have made nondeductible contributions to their IRA, those contributions will not be taxed again if switched to a Roth IRA. However, the government will not allow individuals to convert just those funds to a Roth.
Petrucci said a conversion will be based on the ratio of nondeductible contributions in an individual’s total IRA.
For instance, if 25 percent of a person’s $500,000 IRA are nondeductible contributions and that person wanted to convert only $10,000 to a Roth, he or she will only be allowed to claim $2,500 as nondeductible contributions.
Yet Hickox says individuals can use the tax code to their advantage in another way – with the help of a financial adviser.
He says the rules allow taxpayers to make the conversion to the Roth IRA in January and change their mind and switch back to a traditional IRA before filing a tax return in 2011.
That allows individuals to see how that account performs for a year – and even longer, if the taxpayer files for an extension – before finalizing the Roth conversion.
The advantage: Say a taxpayer converted $100,000 at the start of 2010, and the value of that Roth account dropped to $90,000 over the course of the year. The taxpayer would still owe taxes on the $100,000 conversion when filing the 2010 return, unless the IRA is “re-characterized” as a traditional IRA, Hickox says.
At the same time, a taxpayer could decide to stick with the conversion if the value of the account rises.
“It’s like getting to pick the winner of a horse race after the horses have run,” Hickox says. “It’s really a risk-less strategy.” •
