Estate Planning: Roth IRA Changes

Conversions in 2010 and Beyond

Mary Kay Foss, CPA By Mary Kay Foss, CPA
Greenstein, Rogoff, Olsen & Co., LLP

While similar to a traditional IRA, a Roth IRA distinguishes itself in that contributions aren’t tax deductible and may be made after age 70.5; distributions of earnings are tax free once the account is five years old (other requirements may apply); and no minimum distributions are required during lifetime, but required minimum distributions begin after death for non-spouse beneficiaries.

Roth IRA Contributions
As of Jan. 1, 1998, an individual who meets the income limitations can make an annual nondeductible contribution to a Roth IRA up to the excess of the lesser of $5,000 currently or 100 percent of the individual’s earned income, minus the aggregate amount of contributions for the tax year to all other individual retirement plans (other than Roth IRAs or employer contributions to Simplified Employee Pension and Simple IRAs) maintained for the benefit of that individual. An additional $1,000 (formerly $500) “catch up” contribution is allowed for a person over 50.

Unlike a traditional IRA, there is no age limit for Roth contributions. Individuals over age 70.5 with earned income may contribute for themselves and for a nonworking spouse if income limitations are met. Earned income is defined in the same way as for traditional IRA contributions, thus taxable alimony and separate maintenance payments will qualify.

Participants in Sec. 401(k) and 403(b) plans can participate in Roth versions called Designated Roth IRA Accounts (DRACs). Income tax deductions (or income exclusions) will not be available for contributions to these plans, but the amounts will grow tax-free.

Taxpayers who qualify for an IRA must determine if they are better off using a tax deductible or nondeductible retirement vehicle. It’s possible to split the maximum contribution between a Roth and a traditional IRA (either deductible or nondeductible), but the added complexity may not be worth dealing with. Similarly, the maximum DRAC contribution can be split with a Sec. 401(k) or 403(b) deferral.

Employees covered by an employer plan are not precluded from contributing to a Roth. Individuals covered by a Keogh, SEP or SIMPLE IRA also qualify for Roth contributions.

The income limitations prohibit participation by many interested taxpayers. A single person or head of household qualifies for the maximum Roth IRA contribution when 2010 modified adjusted gross income is $105,000 or less. A partial contribution is allowed when the modified adjusted gross income is greater than $105,000 and less than $120,000.

Joint return filers need less than $167,000 of 2010 modified adjusted gross income to make the maximum contribution. If the limitation is met, both spouses can contribute the maximum. When the modified adjusted gross income exceeds $177,000 no contributions can be made; a reduced amount is allowed between $167,000 and $177,000.

Married couples filing separate returns cannot contribute the $5,000 maximum. The phase-out range allowing a lower contribution ends at $10,000 of modified adjusted gross income.

The contribution for a tax year must be made no later than April 15 of the following year. Extending the tax return does not extend the time period for making contributions.

Conversion to a Roth IRA
Traditional IRAs and certain other retirement plan benefits can be converted to a Roth IRA via a rollover or direct transfer, or by designating an existing account as a Roth account. But there’s a price to pay: Income taxes are paid as though the converted account had been distributed in a taxable distribution.

A taxpayer already receiving required minimum distributions cannot roll over the current year’s RMD into the Roth. An inherited IRA cannot be converted to a Roth IRA.

The major hurdle in converting an IRA to Roth had been the income limitation. Before 2010, single taxpayers, heads of households and married persons filing joint returns all must have a modified adjusted gross income no greater than $100,000 to convert to a Roth IRA. A married person filing a separate return could not convert at all.

Certain adjustments are made to determine modified adjusted gross income. First, the taxable amount of a Roth IRA conversion is not taken into account for purposes of other provisions based upon modified AGI, but is considered in determining taxable income. A number of deductions and exclusions must be added back: traditional IRA deduction, student loan interest deduction, foreign earned income exclusion, foreign housing exclusion or deduction, exclusion of qualified bond interest shown on Form 8815, exclusion of employer-paid adoption expenses shown on Form 8839, and exclusion of required minimum distributions from IRAs for someone over age 70.5.

The modified adjusted gross income limits will still apply for Roth contributions after 2009, but the rules allow taxpayers to get around the modified AGI limit for Roth contributions. Assuming someone’s AGI is too high for a Roth contribution in 2010 or later, they can contribute to a nondeductible IRA then immediately roll the contribution over to a Roth.

Before 2008, a Roth conversion could only be made from an IRA. Keogh sponsors, Sec. 403(b) and qualified plan participants had to roll benefits into an IRA first before moving on to the Roth.

Currently, in addition to IRAs, conversions can be made from: retirement benefits accumulated in an IRC Sec. 401 qualified plan trust; an annuity plan described in Sec. 403(a); an annuity contract described in Sec. 403(b); an eligible governmental deferred compensation plan described in Sec. 457(b); or a military death gratuity under Sec. 1477 of title 10, United States Code, or Sec. 1967 of title 38 of such Code, except for amounts contributed to Coverdell education savings account under Sec. 530(d)(9).

2010 and Later Conversions
As of Jan. 1, 2010, there is neither an adjusted gross income test nor does filing status matter. However, required minimum distributions still may not be part of a Roth IRA conversion.

For 2010 Roth conversions, taxable income is reported one-half each in tax years 2011 and 2012. At the taxpayer’s election, all of the income may be reported in 2010. Married persons have one advantage if they are both contemplating Roth conversions: One spouse can elect 2010 taxation while the other uses the 50-50 default.

The election is made on the 2010 tax return. Presumably the election could be changed by Oct. 15, 2011 even if the tax return was filed earlier.

Income Taxes Payable on Conversion
The entire rollover amount will be subject to income tax under the following conditions:

  • The IRA/retirement plan consists only of prior tax-deductible contributions and no nondeductible contributions have ever been made; or
  • The IRA is a rollover from the qualified plan of a current or former employer with no after-tax contributions.

Nondeductible IRA contributions create basis, which is always recovered on a pro-rata basis. You cannot convert only nondeductible IRAs to a Roth. An inherited benefit can be converted to a Roth IRA by a nonspouse beneficiary of a qualified plan if the beneficiary qualifies under the rules of Sec. 402(c)(11). If this is done, the beneficiary must take a required minimum distribution from the Roth IRA the year after the original plan participant’s death just as they would from a beneficiary IRA. An inherited IRA, however, cannot be converted to a Roth IRA.

10% Early Withdrawal Penalty Tax
The 10 percent tax for making distributions before age 59.5 doesn’t apply to a Roth IRA conversion. The 10 percent tax will apply if there’s a subsequent distribution of converted funds within five years of the conversion, unless the person who is making the conversion qualifies for one of the usual exceptions to the 10 percent penalty tax.

Taxation of Roth Withdrawals
Ordering Rules for Withdrawals are needed because more than one source of funds is typical within a Roth IRA. The funds come out in the following order:

  1. Regular contributions;
  2. Conversion contributions on a first-in, first-out basis (taxable portion comes out first, then nontaxable); and
  3. Earnings.

Distributions from a Roth IRA are not subject to income tax in most cases. Income tax could be imposed if the account has been in place less than five years and if the withdrawals exceed the amounts of after-tax contributions and rollovers made to the account. The five-year tax period rule for this purpose can be shorter than five calendar years. For example, if $2,000 were contributed April 15, 2010, for 2009, the five-year period terminates Dec. 31, 2013.

Pay the Lowest Income Tax on Conversion
Will 2010 be the last year the top income tax rate is 35 percent? If so, 2010 is an attractive year for a Roth IRA conversion, provided that the election is made to pay all of the tax with the 2010 return. If Congress does nothing the maximum income tax rate goes to 39.6 percent in 2011.

Roth Conversions Recharacterizations
The value of an IRA account can change dramatically and quickly with the volatility of the stock market. For example, if Jerry converted his $240,000 IRA to a Roth in July 2009, and the Roth IRA’s value Sept. 1 was $200,000, he would be reluctant to pay income tax on an extra $40,000 of income per year.

The solution would be for Jerry to reverse his conversion to the Roth, then reconvert when the assets were at a lower value.

Effective Jan. 1, 2000, there is a waiting period between a recharacterization and a conversion. A reconversion may not be made before the later of:

  1. The beginning of the taxable year following the year that the amount was converted to a Roth IRA, or
  2. The end of the 30-day period beginning on the date on which the IRA owner transfers the amount from the Roth IRA to a traditional IRA by means of recharacterization.

Oct. 15 of the year following the Roth conversion is the last day to recharacterize. The return need not be extended for the deadline to apply.

Conversions of an IRA to a Roth can be undone through trustee-to-trustee transfers before the due date for filing the tax return. The trustee-to-trustee transfer must also remove any earnings on the converted amount being recharacterized. Recharacterized contributions [Sec. 408A(d)(6)] and returned contributions [Sec. 408(d)(4)] must also include an allocable portion of the fund’s net income.

Recharacterization After the Deadline
A private letter ruling may allow a recharacterization after the extended due date of the income return for the year of the Roth conversion.

Taxpayers who make Roth contributions when their modified adjusted gross income exceeds the applicable amount may also want to recharacterize. An amended return—due using the normal three-year statute of limitations—will be required.

A conversion of a Simplified Employee Pension IRA, a simple IRA or a conduit IRA can be recharacterized back into the pre-conversion form. A conversion of a qualified plan can be recharacterized to a rollover IRA, which could be a new IRA or an existing IRA.

Planning Considerations
Retirement accounts can be converted to Roth IRAs every year that it makes economic sense to do so. Consider strategies such as:

  • Convert when IRA values are low.
  • Convert when tax rates are low.
  • Convert each security or asset class to a new separate Roth IRA for ease of recharacterization.
  • Use non-IRA funds to pay the tax on the conversion.

Roth IRA Estate Planning Implications
The Roth IRA is subject to federal estate tax just like any other asset held at death. Unlike the traditional IRA, there are no income taxes on Roth IRA withdrawals once the five-year period has passed. All pre- and post-death appreciation can be enjoyed because there is a full step-up in Roth IRA assets, rather than income from the deceased individual.

Assets used to pay tax on a conversion to a Roth IRA reduce the owner’s taxable estate. Deathbed IRA conversions may be appropriate in certain circumstances to lower combined income and estate taxes.

At the death of the IRA owner, required minimum distributions must begin (a spousal rollover is available). Distributions required at death use the rule in Reg. Sec. 1.401(a)(9)-3 and will be made either over the beneficiary’s life expectancy or pursuant to the five-year rule.

The Roth IRA is an excellent asset for funding a Bypass Trust. Depending on the age of the beneficiaries, there may be a 30-year or longer period of tax-free growth before the Roth IRA is fully disbursed.

A generation skipping trust funded with a Roth IRA is one way to maximize the stretch out. If the oldest beneficiary does not have a lengthy life expectancy, the advantage dissipates.