Roth IRA contributions (George Chamberlain 2007)

An important subset in the field of tax favored retirement savings vehicles is the Roth IRA. Since their inception in the late 1990's, the number of Roth IRA accounts and the total invested in them has grown dramatically. Although most advisors and many clients are familiar with the Roth IRA - and the related Roth 401(k) - there is one aspect of working with the Roth IRA that regularly raises questions and exposes uncertainty among account owners. This aspect is the Roth IRA conversion and the questions result from the complex and changing rules which govern the conversions. This article will address how an advisor may be able to help clients understand and apply the requirements for a successful conversion.

A primary attraction of the Roth IRA is that qualified distributions from a Roth IRA are income tax free. A distribution will be qualified if the account owner has maintained the account for at least five years and has attained age 59½.1 The basis for this favorable tax treatment is that the initial contributions are made in after-tax dollars and are non-deductible. In addition, the amount an account owner may contribute in any given year is limited and an excise tax is applied to excess contributions. Thus, the issue becomes how might a client account owner get more money into a Roth IRA to take advantage of the tax-free growth and distributions the account offers? The statutory solution created by Congress is the Roth IRA conversion, an approach which allows an account owner to convert monies in an eligible retirement plan account to a Roth IRA.

How does the conversion work?

Although the question is simple, the answer is less so and a client account owner wishing to make a Roth IRA conversion must comply with a variety of rules. First, the types of accounts which may be eligible for a conversion are subject to limitation and the rules may vary from year to year.

In 2007, the conversion must be from an IRA and no other retirement plan accounts are eligible for conversion to a Roth IRA. After 2007, any eligible retirement plan account, including a 401(k) account, may be converted to a Roth IRA.2

A SEP or SIMPLE IRA cannot be directly converted to a Roth IRA. However, a distribution from a SEP or SIMPLE IRA may be rolled over into a Roth IRA, though this ability is not available for SIMPLE IRA distributions until at least two years after the account owner began participating in the SIMPLE IRA.3

An inherited IRA, other than an IRA inherited from the account owner's spouse, may not be converted to a Roth IRA.

Any portion of one or more eligible retirement plan accounts may be converted, without limitation. Conversion to a Roth IRA is not affected by the one tax-free rollover per year statutory limitation that applies to traditional IRAs.

Second, the type of taxpayer account owner eligible to convert an account to a Roth IRA is limited in certain situations, including:

In the years 2007-2009, as in prior years, taxpayers with an adjusted gross income over $100,000 are not eligible to make a Roth IRA conversion. Interestingly, this limit applies equally to single, head of household and married filing jointly taxpayers.

Calculation of the taxpayer's AGI for purposes of the current limitation on conversion eligibility does not include the amount to be converted to the Roth IRA. Further, if the taxpayer is already receiving required minimum distributions from other accounts, the RMDs do not count towards the calculation of AGI for the current limitation.

In most cases, a taxpayer with a filing status of married filing separately is not permitted to make a Roth IRA conversion.

In years after 2009, the $100,000 AGI limitation is removed and even high income taxpayers will be eligible to convert to a Roth IRA.4

Just as an account owner may make contributions to a Roth IRA even after attaining age 70½, conversions to a Roth IRA may take place at any age.

Third, the amount of the account that is being converted to a Roth IRA is subject to income taxation for the year of the conversion, with a variety of consequences to the account owner performing the conversion depending on how the taxes are to be paid.

The entire amount of any pre-tax contributions and any appreciation in the converted account is subject to income tax. Any after-tax contributions are not, however, included in the taxable amount, since income taxes were already paid.5 The account owner cannot choose to roll over only those amounts that represent after-tax contributions to an IRA.

The amount that is converted to the Roth IRA is taxed at the account owner's normal income tax rate. This means that the account owner may find him or herself in a higher tax bracket, depending on the amount converted.

A qualified conversion is not subject to the ten percent early withdrawal penalty tax, even if the account owner has not yet attained age 59½. The early withdrawal penalty will potentially apply if the client owner later makes an early withdrawal from the Roth IRA following the conversion.

Further, if the income taxes due on the conversion are paid from a portion of the funds in the tax-deferred account being converted, that portion of the distribution may be subject to the ten percent penalty tax.

For conversions made in 2010, payment of the income taxes due may be deferred to 2011 and if the account owner so elects, taxes will be payable over a two-year period, including 2011 and 2012.6

Finally, there are three ways in which the conversion may be accomplished administratively as a rollover by the account owner, including:

a qualified rollover from the traditional IRA to the Roth, generally within the sixty day time period allowed by statute when a distribution is made from the IRA;

a trustee to trustee rollover where the funds go from an IRA held in one plan to a Roth IRA held in another plan; or,

designation of a new account with the current IRA trustee whereby funds flow to the new Roth IRA while remaining in the same plan.

In light of these rules, it is possible that an account owner may erroneously enter into a conversion despite being ineligible. In such case, the account owner may be able to obtain relief from the IRS for a good faith error or may be able to "recharacterize" the transaction as a permissible one. When an account owner recharacterizes an attempted and failed Roth IRA conversion as a transfer to an IRA, for example, the account owner must wait until the next taxable year before again attempting to convert the account to a Roth IRA.

Advantages and disadvantages

Which approach is the best for a client considering a Roth IRA conversion? The decision is certainly going to be dependent on the personal situation of the client account owner and the answer may vary from case to case. Assuming an account owner is eligible to enter into a Roth IRA conversion, what might the most important considerations?

One of the greatest attractions of the Roth IRA is the fact that assets held in the account may appreciate and thereafter be distributed without the burden of income taxes going forward. This advantage is the primary motivator for account owners to convert their eligible retirement accounts to Roth IRAs. An additional advantage is that with the Roth IRA there are no minimum required distributions or a required beginning date, unlike the rules applicable to the previously untaxed funds held in traditional IRAs, 401(k) plans and the like. This makes the Roth IRA a very attractive vehicle for building and transferring wealth to the next generation.

The flexibility available to an account owner in the process of the conversion is attractive as well, and may overcome some of the potential disadvantages of the conversion process. One particularly good example is based on the account owner's ability to convert only so much of his or her existing eligible retirement account balance as seems desirable. This may be important where the account owner does not have enough cash available to pay the income taxes that would be due on the entire account balance or when converting too much of a large account would have the undesirable result of pushing the account owner into a higher tax bracket.

There is potentially a downside to choosing the Roth IRA conversion as well. One obvious disadvantage is that income taxes must be paid currently and when the account owner is in a high tax bracket at the time a conversion is being contemplated, the tax burden may be a deterrent to the conversion. This problem would be exacerbated where the account owner expects to be in a lower tax bracket in future years and a traditional IRA works best in this situation.

Another potential drawback would be payment of income taxes on current valuation of the converted account only to see account values drop due to investment selection or overall market performance. Future, unknown changes in the tax laws also pose a threat to those who opt for conversion - adoption of a flat tax or national sales tax are possibilities, though remote at this time, and there is always a chance that Congress will place restrictions on these accounts or change the distribution rules. However, keep in mind that we must perform the analysis and offer a recommendation based on what the law is and how it affects the client's current and anticipated situation.

How might we model the conversion?

Our underlying assumption is that the client and the account are eligible for the Roth IRA conversion. The starting point is with the existing account or accounts that the client plans to convert to a Roth IRA. In the year, or years, of the planned conversion, a withdrawal must be entered to reflect pulling the funds out of the tax deferred account as a part of the process of conversion.7 A contribution to tax exempt holdings - the Roth IRA - will be modeled with the same timing. When the client anticipates conversions occurring over several years, modeling precise amounts becomes more difficult due to the likelihood of changes in the value of the account(s) being converted. If these accounts fare well, then more funds may be available for conversion while poor markets may mean that a smaller amount will be converted and added to the Roth IRA.

A major modeling issue involves the income taxes due on the converted amounts. If the client is not retired and will pay the additional taxes from current income, then no data entry is required to reflect that payment. The absence of a specific cash flow for income taxes as a part of the modeled scenario may be discomforting for some clients as well as for those advisors who prefer to have each cash flow illustrated even when the portfolio is unaffected. In this situation, it is possible that the client will be saving less in those years where additional income taxes are being paid to complete the conversion and this savings reduction should be modeled where applicable and will provide a basis for explaining the flows.

Where the client is already retired or will fund the additional taxes from taxable accounts, modeling a withdrawal for the anticipated tax burden associated with the conversion will be necessary. This withdrawal should be limited to the amount of income tax attributable to the conversion as the analysis will handle the ordinary income tax burden under standard assumptions. This cash flow will provide the desired trail for the client and may be helpful in highlighting the actual costs of the conversion.

A different analysis applies where the client lacks the funds to pay the income taxes due on conversion and elects instead to pay the additional taxes from the account being converted. If the tax monies are supplied from the tax-deferred account being converted to a Roth IRA, there may be a penalty tax on the withdrawal in addition to the regular income tax owed on the amounts withdrawn to pay the conversion taxes, apart from the amounts actually converted. The necessity of paying income taxes on everything that is distributed from the account being converted, whether to fund the Roth IRA or to pay taxes, means that the client will, in effect, be paying taxes on the taxes.

For purposes of modeling, it may be helpful to note that although contributions to a Roth IRA must be made in cash, a traditional IRA may own property. A conversion may effectively rollover property from an IRA to the Roth IRA and this ability may be useful for a client seeking to move certain types of property into an account that is both free of income tax and free of any distribution requirements.

Summary

When a client brings up the question of a Roth IRA conversion, there is usually no quick or simple answer. The client's particular situation must be examined with the object of ascertaining eligibility and then desirability. An analysis should be run to determine the impact of a conversion on the client's current recommendation and in light of anticipated future events. This may be compared with an analysis that does not implement the conversion so that the benefits - or detriments - may be more apparent.

Understanding the complexities of the Roth IRA conversion...This is the future of financial advising.