By Tim Hilger, CPA, Spidell Publishing, Inc.
According to a recent study by USAA, 9% of Baby Boomers with AGIs of $100,000 or more are planning to do a Roth IRA conversion in 2010, and more than half (57%) are not aware that the income limits on conversions are eliminated in 2010.1
As such, 9% of the total are doing conversions but only 43% of the total are aware of the opportunity. This translates to 21% of those who are aware. There’s no reason to think you wouldn’t find the same rate among the unaware were they made aware.
This means two things:
- Most tax pros will have several clients doing conversions, even if there’s no increase in the 9% rate; and
- Since higher-income taxpayers are more likely to use the services of a tax pro, we may have to face up to the prospect that, collectively, we’ve done a poor job of letting our clients know about this opportunity.
In addition to the elimination of the AGI limitations, there are two additional reasons a taxpayer might want to do a conversion in 2010. First, the income can be deferred and spread over two years. Second, in a sagging economy, a taxpayer whose income is down may want to report the (inevitable) income from a traditional IRA while they’re in a lower tax bracket.
AGI limitations eliminate
In taxable years beginning after December 31, 2009, the AGI limitation that has prevented many taxpayers from converting traditional IRAs to Roth IRAs is eliminated.2
In addition, there is a one-time bonus in the law regarding income recognition. A taxpayer who makes a conversion in 2010 may elect to recognize all the income in 2010 or spread the income over the next two years. The wording of the law is a bit odd: “…shall be so included ratably over the two-taxable-year period beginning with the first taxable year beginning in 2011.”3
What this means is that if a taxpayer makes the conversion in 2010, he or she recognizes half the income in 2011 and half in 2012. The taxpayer may, however, elect to recognize all of the income in the year of conversion.
EXAMPLE: In 2010, Irene converts her traditional IRA worth $10,000 to a Roth (she has no basis). She may recognize $5,000 in 2011 and $5,000 in 2012. Alternatively, she may elect to recognize the full $10,000 in 2010.
Before implementing this strategy, keep in mind these two important points that may detract from the benefits of the strategy:
- Tax rates are scheduled to go up in 2011. This, of course, may or may not be true depending on the political climate over the next couple of years; and
- Under the distribution ordering rules, all of the taxpayer’s IRAs are combined.4 This can lead to undesirable results for a high-income taxpayer making a partial conversion.
EXAMPLE: Ira makes nondeductible IRA contributions totaling $22,000 in the years 2006 through 2009. He has no other IRA accounts. In 2010, when Ira’s IRA has a value of $26,000 (including contributions of $22,000 and $4,000 of earnings), he converts it to a Roth.
Unless he elects otherwise, Ira will report no income in 2010, $2,000 in 2011 and the remaining $2,000 in 2012. Or, he may elect to recognize the entire $4,000 in 2010.
However, suppose in his younger years, he had made deductible IRA contributions. Those accounts now have a combined value of $74,000 and no basis, bringing the total value of his IRA accounts to $100,000 ($74,000 + $26,000). He converts the account that holds the $26,000 in 2010.
In this case, he may only use 22% of his IRA basis ($22,000 ÷ $100,000). As such, he uses basis of $5,720 (22% × $26,000). His taxable amount is $20,280 ($26,000 - $5,720).
Contributing to a Roth IRA can be a no-brainer for an individual nearing retirement age with a few extra dollars to save. But does that same taxpayer benefit from a Roth conversion? Sometimes yes, and sometimes no.
Consider such issues as tax bracket, income fluctuation, and estate tax considerations when making the decision to convert a traditional IRA to a Roth IRA.
Individuals nearing retirement are often in the top tax bracket. If an individual will drop to a lower bracket in the next few years, paying the tax on the Roth conversion now may not compensate for tax-free income later.
But, if a taxpayer currently has a low-income year, consider converting the traditional IRA to a Roth IRA. Taxpayers with large business losses, net operating losses (NOLs), or large itemized deductions combined with low income are good candidates.
When a taxpayer has an NOL, itemized deductions and personal exemptions often go unused. This is the perfect opportunity to convert all or a portion of a traditional IRA to a Roth IRA. Estimate how much can be converted without creating taxable income. Converting too much will result in taxable income at the lowest tax bracket. Converting too little will waste those personal deductions.
EXAMPLE: Terry has a $100,000 NOL carried forward from the prior year. His current AGI is $5,000 after applying the NOL. Terry’s itemized deductions and personal exemptions will be $20,000. Terry should convert at least $15,000 from his traditional IRA to a Roth. This will bring his taxable income to zero.
The charitable contribution deduction is based on federal AGI. For most contributions, the law allows up to 50% of AGI. Unused contributions may be carried over for five years before they expire. If a taxpayer is in danger of losing charitable contributions, doing a Roth conversion will:
- Increase AGI;
- Increase charitable contributions by 50% of the AGI increase; and
- Increase taxable income by only 50%.
The net effect of this plan is to cut in half the tax on the Roth conversion.
AGI and passive losses
Taxpayers with rental real estate properties may deduct up to $25,000 of losses generated by those properties. However, the $25,000 maximum allowance is phased out at the rate of 50% of the amount by which the taxpayer’s AGI exceeds $100,000.
As such, taxpayers who have losses from active-participation rental activities want to keep their AGI below $100,000. Doing a Roth conversion in one year prevents increasing the AGI each year the taxpayer draws an IRA distribution because doing the conversion converts future taxable income into tax-free Roth distributions. Even if the taxpayer is at the maximum tax rate of 28%, the cost to draw the taxable IRA could be up to 42% if it causes the taxpayer to lose the use of passive losses.
Social Security taxability
Social Security benefits are tax-free below certain income thresholds. Taxpayers who will be receiving Social Security benefits want to keep their AGI below the thresholds to limit taxability of Social Security benefits. Just as with passive losses, there can be a “double whammy.” An increase in income from one source, such as a taxable IRA distribution, can cause a secondary increase in taxable income in the form of an increase in the amount of Social Security benefits subject to tax.
Converting a traditional IRA to a Roth in the year(s) prior to taking Social Security may reduce taxable Social Security.
Estate planning issues
Although a Roth IRA is includable in the gross estate and is subject to estate tax in the same manner as a traditional IRA, beneficiaries receive the income tax-free. Also, there is no income in respect of a decedent (IRD), which means:
- High-income beneficiaries get the maximum inheritance; and
- Beneficiaries do not have to calculate IRD each time they take a distribution from the plan.
Middle-income parents with high-income children may maximize the value of the estate to the children by doing a Roth conversion. This works best for parents who are not yet drawing Social Security, because the Roth conversion income may increase taxable Social Security.
Make nondeductible contributions now
Consider making nondeductible contributions to a traditional IRA now and converting in 2010. The most likely candidates for this strategy are active participants in employer plans who are prevented from deducting contributions to their IRAs. The deadline for making a 2009 nondeductible contribution is April 15, 2010. As such, an individual may make their contribution on that date and immediately convert it.
Keep in mind, however, the caveat noted above regarding the distribution ordering rules. This strategy may only work for individuals who do not have large balances in IRAs with little or no basis.
De facto elimination of Roth contribution limits?
The post-2009 law eliminates the AGI limitation on Roth conversions but it does not eliminate the AGI limitations on Roth contributions. However, there does not appear to be anything to prevent a taxpayer from making a nondeductible contribution to a traditional IRA beginning in 2010 and then immediately converting it to a Roth. (Note: If the contribution to the traditional would otherwise be deductible, the taxpayer would have to elect to treat it as nondeductible.5) By making the contribution and immediately converting it, the conversion is tax-free. Again, due to the distribution ordering rules, this strategy would only work if the taxpayer has no IRAs with little or no basis.
It seems unlikely that Congress intended this strategy to work. If this strategy had been their intent, it seems they would have likewise eliminated the AGI limitations of Roth contributions. On the other hand it, also seems like we should expect technical corrections legislation or preventive regulations by now since the law was enacted four years ago and we’re just a few months away from its activation.
We have provided a client letter to advise your clients of the new changes they can use to provide you with basic information about their IRAs and other retirement plans.
You can download it at http://www.caltax.com/Spidellweb/pdf/IRAclientletter.doc
1 “Survey Finds Few Plan Roth IRA Conversions in 2010,” (August 17, 09) USAA Newsroom, https://www.usaa.com/inet/ent_blogs/Blogs?action=blogpost&blogkey=newsroom&postkey=survey_finds_few_plan_roth
2 TIPRA ’05 (P.L. 109-222)§512
3 TIPRA ’05 (P.L. 109-122)§512(b)(1)
4 IRC §72(t); Treas. Reg. §671.408A-6
5 IRC §408(o)(2)(B)(2)