What is a Roth (IRA)?

A Roth IRA is an Individual Retirement Account named after the late Senator William V. Roth, Jr., (R-Delaware) that allows you and your spouse to make non-deductible contributions to save for retirement. However, rather than growing on a tax-deferred basis, all “qualified” distributions are made on an income tax-free basis.
There are currently three ways to fund a Roth IRA. You can contribute directly, you can convert all or part of a traditional IRA to a Roth IRA, or you can roll funds over from an eligible employer retirement plan.

For 2009 and 2010, an individual may directly contribute the lesser of $5,000 or 100% of compensation for the year to a Roth IRA. For a married couple, an additional $5,000 may be contributed on behalf of a lesser earning (or nonworking) spouse, using a spousal account. Additionally, if an IRA owner is age 50 or older, he or she may contribute an additional $1,000 ($2,000 if your spouse is also age 50 or older).

As with many tools that offer tax advantages, Congress has limited who can contribute to a Roth IRA, based upon income. A taxpayer can only contribute the maximum amount if their Modified Adjusted Gross Income (MAGI) is below a certain level. Otherwise, a phase-out of allowed contributions runs throughout the MAGI ranges shown below. Once MAGI hits the top of the range, no contribution is allowed at all.
The ranges, for 2009 and 2010, are as follows:

Roth IRA Contribution Limits

MAGI Phase-Out Ranges	2009	2010
Single Individuals	$105,000 - $120,000	$105,000 - $120,000
Married filing a joint income tax return	$166,000 - $176,000	$167,000 - $177,000
Married filing separate tax returns	$0 - $10,000	$0 - $10,000

Roth IRA Strengths

Qualified Distributions Are Completely Income Tax-Free

A withdrawal from a Roth IRA (including both contributions and investment earnings) is completely income tax-free and penalty free if (1) made at least five years after you first establish any Roth IRA, and (2) one of the following also applies:

You have reached age 59½ by the time of the withdrawal

The withdrawal is made due to qualifying disability

The withdrawal is made for first-time homebuyer expenses ($10,000 lifetime limit)

The withdrawal is made by your beneficiary or your estate after your death

Withdrawals that meet these conditions are referred to as “qualified distributions”. If the above conditions aren't met, any portion of a withdrawal that represents investment earnings will be subject to federal income tax and may also be subject to a 10 percent premature distribution tax if you are under age 59½.

No Required Minimum Distributions starting at age 70 ½ so Your Funds Can Stay in a Roth IRA longer than in a Traditional IRA

The IRS requires you to take annual required minimum distributions from Traditional IRAs beginning when you reach age 70½. These withdrawals are calculated to dispose of all of the money in the Traditional IRA over a given period of time. Roth IRAs are not subject to the required minimum distribution (RMD) rule. In fact, you are not required to take a single distribution from a Roth IRA during your life (although distributions are generally required after your death

You Can Contribute to a Roth IRA after age 70½

Unlike Traditional IRAs, you can contribute to a Roth IRA for every year that you have taxable compensation, including the year in which you reach age 70½ and every year thereafter.

No Income Taxation to Your Beneficiaries on Withdrawals From Inherited Roth IRAs

As long as any Roth IRA you established had been in existence for at least five years at the time of your death, your beneficiaries will not have to pay any federal income tax on post-death distributions. Even if you haven't satisfied the five-year holding period at the time of your death, distributions to your beneficiary will still be tax free if he or she waits until the date you would have satisfied the five-year holding period before taking distributions. This can be a significant advantage in terms of your estate planning.

Should You Convert?

There is no minimum or maximum amount that can be converted. As part of your decision to convert existing IRAs to a Roth IRA, you need to weigh the pros and cons. Some reasons influencing a decision to convert to a Roth IRA include the following:

You anticipate higher tax rates in the future.

You have a long investment time frame.

While your retirement investments have declined in value due to last year's market correction, you anticipate them to rebound at some point before you retire.

You prefer delaying retirement distributions as long as possible and would like to avoid taking withdrawals upon reaching age 70.5.

You have money available to pay the taxes due on the conversion.

You hope to leave your beneficiaries a tax-free gift.

The majority of your IRA’s are comprised of post-tax contributions, resulting in a minimal tax from your conversion.

Conversely, the primary reasons influencing a decision not to convert to a Roth IRA include the following:

You do not believe in prepaying income taxes given uncertainty about the tax code, future tax rates and other tax legislation.

You have a large amount of money in a rollover IRA, SEP-IRA or SIMPLE IRA, which would result in a sizeable tax burden on each IRA dollar converted.

You are unsure that the IRS will continue to allow qualified distributions from Roth IRAs to be tax-free in the future.

You will need to withdraw money from your converted Roth account to pay taxes due on the conversion.

There is one additional item to consider for 2010 conversions only. The amount that you convert in 2010 can be included as income in tax years 2011 and 2012. For example, if $50,000 is converted in 2010, $25,000 can be included as conversion income in 2011 and $25,000 in 2012. However, don't forget that rates may be on the way up in 2011 since the tax cuts enacted as part of the 2001 Tax Act are set to sunset at the end of 2010. Therefore, conversion income can be included on your 2010 income tax return if you anticipate an increase in tax rates.

Calculating Income to Report on a Roth IRA Conversion

We have been telling our clients to begin (or continue) making non-deductible contributions into their IRAs each year since 2007 in anticipation of the conversion rules changing. The higher the percentage of post-tax dollars (these are tracked by Form 8606, which is attached to your federal income tax return) to the total value of your IRAs, the smaller the tax burden on the amount converted.

A Few Examples

Let’s look at an example of how you will be taxed on a Roth conversion, assuming you currently have only one IRA account funded with $23,000 of non-deductible IRA contributions going back to 2006. If your IRA is worth $30,000 on the date you convert it to a Roth IRA, you will owe taxes on $7,000 of income (FMV of $30,000 less post-tax contributions of $23,000) – which is not bad to end up with $30,000 in a Roth IRA.

But what happens if you also have a rollover IRA or SEP-IRA worth $200,000? In this example, since your post-tax IRA contributions remain at $23,000 but your total IRA value jumps to $230,000, the cost basis of your IRAs drops to just 10% of your total IRA balance ($23,000/$230,000). Therefore, if you convert your $30,000 IRA to a Roth IRA, you now only shield $3,000 of the amount converted from taxes, and should expect to be taxed on $27,000 of income.

Taxability of a Roth Conversion

	$30k IRA	$230k IRA
Total post-tax contributions	$23k	$23k
Value of IRA account	$30k	$30k
Value or Rollover IRA (or SEP IRA)	$-0-	$200k
Total Value of all IRAs	$30k	$230k
Post-tax contributions as % of all IRAs	76.67%	10%
Amount Converted	$30k	$30k
Taxable % on Amount Converted	23.33%	90%
Taxable Income on $30k Roth Conversion	$7k	$27k

Save Taxes with a Roll Out

If you have made non-deductible contributions to your IRAs over the years, you might be able to save significant taxes on your Roth conversion by taking advantage of this strategy included on page 23 of IRS Publication 590, Individual Retirement Accounts (IRAs):

Tax treatment of a rollover from a traditional IRA to an eligible retirement plan other than an IRA.

Ordinarily, when you have basis in your IRAs, any distribution is considered to include both nontaxable and taxable amounts. Without a special rule, the nontaxable portion of such a distribution could not be rolled over. However, a special rule treats a distribution you roll over into an eligible retirement plan as including only otherwise taxable amounts if the amount you either leave in your IRAs or do not roll over is at least equal to your basis. The effect of this special rule is to make the amount in your traditional IRAs that you can roll over to an eligible retirement plan as large as possible.

Basically, the IRS is reminding you in their Publication 590 on IRAs that you have the option of rolling money out of your IRAs into an employer sponsored plan that accepts IRA rollovers. And when you roll money out of an IRA, the non-deductible contributions remain within the IRA.

In our second example above, what would happen if that person rolled his $200,000 Rollover IRA into his 403(b) account at work? In this updated example, the total fair market value of his IRAs would revert to just $30,000, so the taxable income on the conversion would be the same $7,000 as in the first example. This person’s taxable income, therefore, would decrease by $20,000. That’s a pretty good return on your investment of a few minutes of time spent completing some paperwork.

One way to push this opportunity even further is to convert the exact amount of the post-tax IRA contributions you made over the years, and roll out the remaining IRA balance into your 401(k) or 403(b) account at work. This strategy allows you to get the maximum amount of money into your Roth IRA without paying any taxes at all.

If you are skeptical of this strategy, you can read through the instructions to Form 8606. You also need to check with the retirement plan administrator at work to confirm whether your employer’s 401(k) or 403(b) plan accepts IRA rollovers.

What If You Change Your Mind After Converting?

If you change your mind about a conversion, you may undo it through a “recharacterization”, which returns the assets to a traditional IRA. You will receive a refund of any income tax paid on the conversion income. If you have not paid the tax, then the tax liability would be removed. You may do a recharacterization up to the due date of the return plus extensions, which is typically October 15 of the year after the conversion. For example, a conversion done on January 15, 2010 can be recharacterized until October 15, 2011. If the value of an IRA falls sharply soon after you convert it, you could recharacterize the assets and then reconvert at a lower value.

Summary

The Tax Increase Prevention and Reconciliation Act of 2005 eliminated the income limit and allow high-income taxpayers, including physicians, to convert their IRAs and other eligible retirement accounts to a Roth IRA as of January 1, 2010. If the tax-free benefits of a Roth IRA are appealing, collaboration between your financial advisor and tax professional is essential. While Roth IRAs provide a superior way to build tax-free growth, converted assets will most likely increase your Adjusted Gross Income (AGI) and tax liability. Your CPA should be able to help you determine the ramification of the conversion and help you make an informed, intelligent decision regarding a Roth IRA conversion. A small amount of planning may result in a large amount of income tax savings.