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Planning Opportunities with IRAs – the Roth Conversion

    Client Alerts
  • November 01, 2010

As of January 1, 2010, the income limitations on the ability to convert a traditional IRA to a Roth IRA were eliminated. Taxpayers earning over $100,000 per year may elect to convert a traditional IRA account to a Roth IRA. Unlike a traditional IRA, distributions from a Roth IRA are not included in gross taxable income. Additionally, there are no minimum distributions from a taxpayer’s Roth IRA (although such rules apply to inherited Roth IRAs). Please note that contributions to a Roth IRA are not deductible and the value of the traditional IRA account that is converted is included in the taxpayer’s taxable income in such year and subject to income tax at current rates. Even considering the resulting tax upon conversion, it is worth a closer look.

First, assuming that the conversion is done prior to any legislation that increases income tax rates (unlikely to occur in the current year), it may be possible to “lock in” a lower effective tax rate (assuming that future tax rates will be higher) on the amount converted. Next, by converting a portion of a traditional IRA to a Roth IRA, a taxpayer has “diversified” their IRA assets by providing the opportunity to take distributions from a Roth IRA, which are not subject to income tax, in order to minimize the overall income tax in a given (future) tax year. Additionally, for taxpayers with potentially taxable estates comprised of significant IRAs, conversion of a traditional IRA to a Roth IRA may provide an opportunity to reduce estate taxes (by payment of the income tax liability resulting from the conversion), as well as providing the taxpayer’s heirs with the benefit of having paid the income taxes on an asset that otherwise would be subject to income taxes on withdrawal by the heirs. Finally, pursuant to the Health Care Reform Act, a 3.8% surtax becomes effective as of January 1, 2013 and traditional IRA distributions may be a factor in whether the surtax is applicable.

The surtax is imposed on the lesser of (1) a taxpayer’s net investment income and (2) the excess of a taxpayer’s modified adjusted gross income (MAGI) over the threshold amount. While IRA distributions are not included in net investment income, distributions from traditional (but not Roth) IRAs are included in MAGI. The threshold amount is $200,000 for a single taxpayer and $250,000 for married taxpayers. While this may seem like a fairly complex formula, the application of the surtax is fairly straight forward. For example, assume that in 2014, Mary, a single taxpayer over the age of 70 ½, has net investment income (which does not include distributions from her IRA) of $100,000 and receives a distribution from her IRA of $200,000. The application of the surtax is as follows if the distribution is from a traditional versus a Roth IRA:

Investment Income $100,000 $100,000
IRA Distribution (included in MAGI) $200,000 $ 0
MAGI $300,000 $100,000
Threshold Amount $200,000 $200,000
Amount Subject to Surtax $100,000 $ 0
Surtax @ 3.8% $ 3,800 $ 0

If the IRA is a traditional account, the $200,000 distribution is included in Mary’s modified adjusted gross income so that her MAGI is $300,000, exceeding the threshold amount (of $200,000) by $100,000. However, if Mary’s IRA is a Roth IRA, the distribution is not included in Mary’s MAGI and she will not be subject to the surtax.

The decision on whether to convert an IRA is a challenging one – particularly because it comes with an immediate tax cost – but, there are a number of positive factors to consider and we would be happy to review those considerations with you.