Jesse Palmer

Roth IRAs

Roth IRAs have several distinct advantages over traditional IRAs or other qualified retirement plans:

• While contributions are nondeductible, all distributions are tax-free, including earnings
• No required minimum distributions once the taxpayer attains age 70 ½
• Contributions may be made after age 70 ½ as long as the taxpayer has earned income, i.e., wages, self-employment income, etc.
• Distributions to beneficiaries are tax-free (required minimum distributions are required for nonspousal beneficiaries)

Yearly contributions to a Roth IRA are subject to the same limitations as traditional IRAs. For 2009, the limit is the lesser of $5,000 ($6,000 if age 50 or older) or 100 percent of compensation. The allowable contribution amount is subject to a phaseout based on the taxpayer’s modified adjusted gross income (AGI). For 2009, the phaseout range for single taxpayers was $105,000 to $120,000 ($166,000 to $176,000 for married filing jointly).

All or a portion of a traditional IRA may be converted to a Roth. A taxpayer who converts a traditional IRA to a Roth IRA must include all previously deductible contributions and related earnings in gross income at the time of conversion. When a taxpayer has traditional IRAs that include both deductible and nondeductible contributions and does not convert the entire balance, special calculations must be performed to determine the taxable conversion amount.

Recharacterization

Roth conversions are one of the few areas in tax law allowing taxpayers to benefit from a limited amount of hindsight. After converting to a Roth IRA, a taxpayer may determine the conversion was a mistake and want to undo part or all of the conversion. This is accomplished by a trustee-to-trustee transfer of funds from the Roth IRA back to a traditional IRA no later than the due date, including extensions, for the return for the year of the original conversion. For example, a Roth conversion made in 2010 can be undone as late as October 15, 2011. This is especially helpful in cases where the IRA has significantly declined in value from the original conversion date.

Change in Roth Conversion Rules

As a result of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), income and filing status limitations on Roth conversions no longer apply for tax years beginning after 2009. TIPRA also provides an opportunity to defer income resulting from 2010 Roth conversions to 2011 and 2012. If chosen, 50 percent of the taxable amount is included in 2011 income and 50 percent in 2012. The income will be taxed at the marginal income tax rates in effect in those years. Alternatively, the taxpayer can elect to include the entire amount of income in 2010.

Who Should Elect?

Since a Roth conversion requires tax to be paid now instead of at the time of withdrawal, several factors must be considered, including:

• Time Horizon – the longer the period of time between date of conversion and withdrawal, the greater the chance tax-free growth will offset the cost of paying taxes currently
• Ability to Pay Tax – if possible, cash from sources other than the IRA should be used to pay the tax incurred on conversion. This allows more money to build up tax-free within the Roth account
• Projected Future Tax Rates – if you anticipate your marginal tax rate will be higher in the future when withdrawals are made, paying tax on conversion today is more attractive. This also is an important consideration when deciding whether to spread the income from a 2010 Roth conversion to 2011 and 2012
• Future Cash Needs – if other funds will be available to meet your retirement needs, it may make sense to pay tax now for the opportunity to leave a tax-free source of income to your beneficiaries

What Should I Do?