Is It Time to Consider a Roth Conversion?

Is it time for you to consider a Roth Conversion?

Through the years we have often touted the benefits of Roth IRAs to Beacon clients and suggested financial planning strategies for utilizing Roth IRAs. Given the current economic conditions and likelihood of rising income tax rates, we believe that everyone who qualifies should consider a Roth conversion this year.

A Roth IRA refresher

Before considering the merits of a Roth conversion, it is necessary to discuss the benefits of Roth IRAs in general. The following are several advantages of Roth IRAs:

• Qualified distributions from Roth IRAs are not subject to income tax (as they are with 401(k) plans and traditional IRAs).

• Investment earnings are completely tax exempt.

• There are no required minimum distribution (RMD) requirements at age 70 1/2, allowing these accounts to grow tax-free indefinitely.

• Original Roth contributions, including conversions, can be withdrawn prior to the age of 59 ½ without penalty.

When is a Roth Conversion Appropriate?

For 2009, only taxpayers who have a modified adjusted gross income level below $100,000 are eligible to make Roth conversions. With that in mind, here are several scenarios that may present a perfect opportunity for a Roth conversion.

You are over the age of 70 1/2 and normally take required minimum distributions (RMDs)

As a result of battered investment portfolios, Congress decided that in 2009, required minimum distributions from IRAs should be suspended. So, for those taxpayers who do not need their IRA to fund living expenses, it may make sense to take an IRA distribution anyway. IRA holders can pay taxes on the distribution and convert the IRA proceeds into a Roth IRA.

Most brokerage firms (including Schwab) allow their clients to simply move shares of a stock or mutual fund directly into a Roth IRA to facilitate the conversion. By transferring an investment directly, at depressed values, you would essentially have transferred (and paid the taxes on) a depressed asset with the thought that you, or your heirs, would never pay taxes on that investment again.

You temporarily expect to be in a lower income tax bracket in 2009

For many, 2009 will prove to be a year in which income levels decline. In some cases, high income earners have been laid off or have taken a significant pay cut. Suddenly, they may find themselves in a much lower tax bracket.

For people in this category, converting an IRA to a Roth could essentially allow normally high-bracket taxpayers to maximize the lower tax brackets in a low earnings year.

There is a possibility that you will have unused itemized deductions

Some people find themselves in a situation where they have sizable itemized deductions, but their income is so low that some of these deductions go unused. Examples could include, high medical expenses, mortgage interest, property taxes or state income taxes.

For these taxpayers, it may make sense to convert a portion of their IRA into a Roth. This tax planning strategy essentially creates additional income, which enables the taxpayer to make full use of their itemized deductions. Additionally, taxable IRA proceeds are then converted to a Roth IRA and never taxed again.

2010 Roth Conversion Opportunity

In the past, only those taxpayers with an adjusted gross income of $100,000 or less were able to convert existing IRAs into Roth IRAs. Congress has suspended the adjusted gross income limitation for Roth conversions for the year 2010. As such, taxpayers at any income level have the ability to convert their IRAs into Roth IRAs. While this may represent a golden opportunity for some, there are a number of issues to consider prior to making the switch including the following:

• What will be the tax cost for the conversion?

• Will the additional taxes from the Roth conversion be paid from the conversion itself, through paycheck withholdings or through other means?

• Will a Roth conversion create adverse tax implications like the deductibility of medical expenses or increased costs of Medicare Part B premiums?

• Does it make sense to execute a Roth conversion into multiple Roth accounts, to take maximum advantage or the possibility of recharacterizing the conversion at a later date?

We believe that tax rates are likely to rise somewhat over the next decade. Executing a Roth conversion now, while tax rates are low, can represent a significant future tax savings to you and your family. Of course, every situation varies so it is essential to fully consider the tax and non-tax implications when converting IRA proceeds into a Roth.

If you would like to discuss the pros and cons of a Roth conversion given the details of your specific situation, please feel free to contact us to schedule an appointment.

About Beacon Financial Strategies

Beacon Financial Strategies is an independent, fee-only financial planning, tax and investment advisory firm located in Raleigh, NC. Beacon works with clients on a consultative and objective basis to help them achieve their personal financial goals. Beacon professionals specialize in the following areas of financial planning: retirement feasibility planning, estate planning and coordination, investment management, tax minimization strategies, and other wealth management services. Feel free to contact us for more information.