Bader Martin, P.S.

Have an IRA?

Allan G. Steinman, MBA, CPA
Principal, Tax Services; Principal, Accounting and Assurance Services

August 24, 2009

They've heard it's a once-in-a-lifetime opportunity. Now in their mid-50s, April and Brian have always taken planning for retirement seriously and have accumulated significant (although recently diminished) balances in traditional IRAs as part of their retirement funds. They also have smaller balances left in the 401(k) plans of former employers.

Although the couple briefly considered Roth IRAs, they were told that their incomes were too high to consider converting their traditional IRAs or to make future Roth IRA contributions.

Recently, April and Brian heard that certain rules governing Roth IRA conversions are changing. They want to take advantage of every opportunity to maximize their retirement savings but, like many people in similar circumstances, they're not sure they understand Roth IRAs or how to evaluate the new Roth IRA options available to them.

Overview
An individual retirement arrangement, or IRA, is a federally tax-advantaged retirement account available to individual taxpayers. In general, contributions to a traditional IRA are tax deductible and the earnings and contributions are taxed when withdrawn. A Roth IRA is a special form of IRA. Contributions are not deductible when made, but contributions and earnings are tax-free when withdrawn.

Basic Rules for Traditional IRAs and Roth IRAs
You can contribute to an IRA as long as your earned income equals or exceeds the amount of your contribution. If you are married, both you and your spouse can contribute to your own IRAs, even if only one of you had earned income―as long as your combined earned income for the year equals or exceeds the total amount of your IRA contributions.

If you have both traditional and Roth IRAs, any contributions you make to your traditional IRA reduce your potential contributions to your Roth IRA.

The major provisions governing traditional and Roth IRAs are as follows:

	Traditional IRA	Roth IRA
Eligibility
Age limit	Must be under age 70½ as of the end of the tax year to establish and/or contribute	N/A
Modified adjusted gross income (MAGI) limit	N/A	Married filing jointly or qualifying widow/widower: phase-out begins with MAGI of $166,000; contributions not allowed for $176,000 or more Single, married filing separately and not living with spouse, or head of household: phase-out begins with MAGI of $105,000; contributions not allowed for $120,000 or more Married filing separately and lived with spouse during year: phase-out begins with MAGI of $0; contributions not allowed for $10,000 or more
Contributions
Maximum annual amount for 2009 (combined amount, if more than one IRA)	$5,000 (plus $1,000 catch-up contribution if age 50 or older) Limited to taxable income	No difference
Tax deduction	Contributions are tax-deductible for federal income tax purposes A phase-out limits the tax-deductible portion of contributions if you're also covered by retirement plan at work, as follows: Married filing jointly or qualifying widow/widower: phase-out begins with MAGI of $85,000; no deduction allowed for $105,000 or more Single, married filing separately and not living with spouse, or head of household: phase-out begins with MAGI of $53,000; no deduction allowed for $63,000 or more Married filing separately and lived with spouse during year: phase-out begins with MAGI of $0; no deduction allowed for $10,000 or more	N/A
Distributions
Tax treatment (for you and your beneficiaries)	Distributions of tax-deductible contributions and all earnings are taxable as ordinary income Pro-rata distributions of nondeductible contributions are not taxable	Distributions of contributions and qualified distributions of earnings are not taxable Nonqualified distributions of earnings are taxable as ordinary income
Qualified distributions	N/A	Distributions made after initial five-year period, and Made after you reach 59½, made because you were disabled, made to a beneficiary after your death, or made for a first-home purchase
Required minimum distributions (RMDs)	Begin at age 70½ For 2009 only, RMDs are not required	None required for original owner RMDs apply to beneficiary of inherited IRA after original owner's death
Early distributions	Withdrawals before age 59½ are subject to an additional 10 percent tax as penalty, with certain exceptions	Nonqualified distributions of earnings are subject to an additional 10 percent tax as penalty, with certain exceptions
Other implications	Distribution amounts can affect tax brackets, income-based tax deductions, and calculation of taxes on Social Security income	Tax-free distributions don't affect tax brackets, income-based tax deductions, and calculation of taxes on Social Security income

Converting from a Traditional IRA or Employer's Qualified Plan to a Roth IRA
If you're eligible, you can convert the entire balance in your traditional IRA to a Roth IRA―or convert only a portion of the balance, including a pro-rata portion of tax-deductible and nondeductible amounts.

For 2009, you're eligible to convert a traditional IRA to a Roth IRA if your modified adjusted gross income (MAGI) is not more than $100,000 and your filing status is not married filing separately.

  Beginning in 2010, you can convert a traditional IRA into a Roth IRA regardless of your income and filing status.

You can also convert amounts from your employer's qualified pension or profit-sharing plan―including a 401(k) plan―according to the same rules.

It is important to note that the new rules eliminate the income limitations for converting to a Roth IRA, but do not remove the income limitations that govern new contributions to the Roth IRA. However, it may be possible to further increase the balance in your Roth IRA even if your income exceeds the limit by again converting future contributions made to your traditional IRA.

Federal Income Tax Consequences of Converting
When you convert from a traditional IRA or a qualified retirement plan to a Roth IRA it is a taxable event―you will have to pay income tax on all pre-tax contributions and earnings. However, there is a benefit in that these taxes reduce the value of your estate for tax purposes.

When converting from a traditional IRA, all contributions for which you took a tax deduction and related earnings are taxable as ordinary income. Any distributions of contributions for which you did not take a tax deduction are not subject to tax. Similarly, if converting from a qualified plan, you include in income all pre-tax contributions and earnings, and exclude any after-tax contributions to the plan.

Under normal circumstances, the full amount of taxable income resulting from a Roth IRA conversion is reported on your federal income tax return for the year of the conversion.

If you convert in 2010, however, a special provision applies: Unless you elect otherwise, you defer recognition of the resulting income by spreading it over the following two years. As a result, you recognize taxable income and pay the related federal income taxes in 2011 and 2012. The fact that federal income tax rates will increase in 2011 (barring action by Congress) may affect your decision regarding this deferral election.

Factors to Consider in Making the Decision to Convert
The decision to convert from traditional IRA or qualified plan to a Roth IRA is a complex one based on many financial and personal factors, such as your current age and expected age at retirement, the amount of tax due on conversion, whether or not you intend to pay this tax using assets from the IRA, how much you anticipate the assets will increase in value, changes in tax rates over time, the amounts you plan to withdraw after retirement, your current tax bracket and anticipated tax bracket upon retirement, the size of your estate and your plans for the estate, your lifespan, and the potential tax impact on your beneficiaries.

Potential Roth IRA benefits to include in your decision-making are as follows:

  Tax-free growth: The earnings from assets in your Roth IRA are not subject to federal income tax, even when distributed from the IRA. By contrast, traditional IRA earnings are only tax-deferred. While they remain in your IRA they are not subject to tax, but they are taxable as ordinary income when distributed.

  More flexibility for early retirement: You cannot take distributions from your traditional IRA before you reach age 59½ without incurring a significant penalty from the IRS. Early distributions of your Roth IRAs earnings are subject to the same penalty, but you can withdraw your contributions at any time.

  Greater wealth accumulation: The earnings in your Roth IRA are not subject to tax while the earnings in your traditional IRA are only tax-deferred. As a result, you will ultimately pay more in taxes for an equivalent amount invested in a traditional IRA, all other factors being equal.

  Hedge to risk of tax-rate increases: With a Roth IRA, the amounts you contribute are taxed currently. With a traditional IRA, your contributions are taxed years later, when distributed. In an environment of increasing taxes, you hedge your tax-rate risk with a Roth IRA.

  Reduced taxable estate: The federal income taxes you pay when you convert and/or contribute to your Roth IRA reduce the size of your taxable estate.

Because of the many factors involved in this important financial decision―and the significant tax consequences―it's critical that you consult with your tax advisor at Bader Martin before converting to a Roth IRA.


Previous Article	Next Article



Back to Articles