Starting in 2010, high net worth individuals who earn $100,000 or more will be eligible to convert their traditional IRA to a Roth IRA, an opportunity previously unavailable to them.
The popular Roth IRAs were introduced in 1998 and offer the opportunity for completely tax-free withdrawals, a potentially significant long-term advantage over traditional IRAs that face taxes at withdrawal. Roth IRAs also offer additional benefits because they do not require withdrawals after age 70½ unlike traditional IRAs.
The new rules removing the income restrictions on conversions, adopted as part of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), also create a one-time tax incentive to make the conversion in 2010. Those who convert next year will be able to defer the income recognition associated with a Roth conversion over the two subsequent years (2011 and 2012). All other conversions in years after 2010 will generate taxable income in the year of conversion.
While this is a compelling opportunity from a tax perspective, a number of unknowns remain including future tax rates and market performance. It’s expected that tax rates are likely to go higher – especially for wealthy individuals – and Roth IRAs generally make sense in a rising tax environment. And some investors are concerned the conversion value might be higher in 2010 only to fall again later, despite the common perception that a market low point may have passed. Fortunately, Roth rules allow for “re-characterization” or undoing of the conversion in order to re-do it the next tax year if the value of the account falls.
With that said, conversion may make sense for individuals who can say yes to the following considerations:
Can you afford to pay a big tax bill now, especially if you are a high-net-worth investor with a large IRA?
Can you keep the converted amount in the Roth IRA for a minimum of five years as the rules require? Beyond this five-year limitation, withdrawals from Roth IRAs are allowed for higher education expenses, a first-time home purchase, the death or disability of the account holder, or for those aged 59½ or taking a series of equal distributions (72(t) distributions).
Do you anticipate higher tax rates in the future, when you may be taking withdrawals from the account?
Do you understand how the converted amount – included as part of the calculation of your Adjusted Gross Income – impacts other tax deductions or the taxability of Social Security income?
In any case, investors are encouraged to work with a tax advisor who can help them consider all the factors before deciding whether a converting to a Roth IRA is right for them.