No Time Like the Present to Consider a Roth IRA
The Year 2010 offers a new and possibly unique opportunity to shift retirement investments to a “Roth IRA.” Before this year, Roth IRAs were essentially unavailable to high income taxpayers because rollovers, as well as annual contributions, to a Roth IRA could be made only by taxpayers whose incomes did not exceed specified limits. As of January 1, 2010, however, the income limit on rollovers to a Roth IRA has been eliminated. Such rollovers will, however, generally be taxable, so that the benefits of these actions must be carefully calibrated against the tax cost.
The Roth IRA Advantage
A Roth IRA is similar in many respects to the familiar individual retirement account (“Traditional IRA”). However, unlike a Traditional IRA, contributions are not tax-deductible and “qualified distributions” (discussed below) from a Roth IRA are tax-free. Moreover, unlike Traditional IRAs, distributions from a Roth IRA are not required to begin when the owner attains age 70½, and taxpayers who remain employed after that age can continue to make contributions. This presents the possibility of
- tax-free investment gains over the life of the Roth IRA owner, and
- tax-free investment gains over many more years thereafter if the beneficiary of the Roth IRA is the owner’s surviving spouse or a child.
For distributions from a Roth IRA to be free of both income tax and a 10% early withdrawal penalty, the distribution must be a “qualified distribution.” This means that the owner must have maintained the Roth IRA for a 5-year period prior to the distribution, and that the distribution generally must occur after the owner attains age 59½ or the owner’s death or disability.
Amounts that are paid from the Roth IRA other than in a qualified distribution will be subject to tax, except to the extent that they are considered to be a return of the owner's contributions, which are made from after-tax dollars. "Ordering" rules determine the extent to which a non-qualified distribution is considered to be a tax-free return of after-tax contributions
The 2010 Advantage
Even before 2010, middle income taxpayers were allowed to convert a Traditional IRA to a Roth IRA, as long as the owner was prepared to pay income taxes on the previously untaxed amounts transferred from the Traditional IRA. However, conversions were not permitted for taxpayers with adjusted gross incomes exceeding $100,000. Beginning in 2010 the income limit does not apply to a Traditional IRA conversion. Moreover, to encourage such conversions in 2010, one-half of the taxable distribution from the IRA will be includible in the IRA owner’s income in each of years 2011 and 2012, at the tax rates then in effect, unless the owner chooses to be taxed on the entire distribution in 2010 at the 2010 tax rates.
In addition, recent changes to the law have made it a requirement that employer qualified plans (e.g., a 401(k) plan) allow a participant to roll over an “eligible distribution” directly from the plan to a Roth IRA. Previously, it was necessary to first roll a plan distribution to a Traditional IRA and then convert the Traditional IRA to a Roth IRA. The ability to roll over amounts directly from a plan to a Roth IRA greatly facilitates the process of creating a Roth IRA. The new rules above that apply to converting a Traditional IRA to a Roth IRA also apply to a rollover of distributions from an employer plan; that is, the income limits are eliminated beginning in 2010 and one-half of the taxable distribution from the plan in 2010 will be includible in the taxpayer’s income in each of years 2011 and 2012, unless the taxpayer chooses to be taxed in 2010.
Full Speed Ahead?
Deciding whether to convert or roll amounts over to a Roth IRA requires an analysis of many factors and the taxpayer’s goals. For example,
- Will anticipated investment growth in the Roth IRA offset the current taxes on the conversion of a Traditional IRA or rollover from an employer plan?
- Will the taxpayer have to use a portion of his Traditional IRA to pay the taxes on its conversion, thereby reducing the amount contributed to the Roth IRA?
- What does the taxpayer anticipate marginal tax rates will be in the future on distributions from a Traditional IRA that he does not convert to a Roth IRA in 2010?
- Is the taxpayer’s primary goal to provide heirs with a fund that they may draw down tax-free, even if it means paying income taxes on the fund now?
- Does the taxpayer have an adviser to guide him through the decision-making process and the many complex rules that apply to conversions and rollovers?
If you would like to discuss whether a Roth IRA is suitable to your retirement planning needs, please contact your CL&M attorney or the following: Patricia Matzye (212-238-8730, firstname.lastname@example.org), Howard Barnet (212-238-8606, email@example.com) or Jerome Caulfield (212-238-8809, firstname.lastname@example.org).
Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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