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Roth IRA Conversions And TIPRA – Be Careful What You Wish For

Roth IRA Conversions And TIPRA – Be Careful What You Wish For

One of the eye-catching aspects of the Tax Increase Prevention and Reconciliation Act (“TIPRA”) is the ability to convert an IRA to a Roth IRA without income limitations beginning in 2010. By way of reminder, the law currently in effect (and continuing until 12/31/2009) states that taxpayers with adjusted gross income (“AGI”) less than $100,000 are eligible to convert to a Roth IRA.

At first glance, this seems like a decided benefit for the affluent. After all, the Roth IRA is far superior in that it contains beneficial provisions such as tax-free distributions and no required minimum distributions at age 70 1/2.

However, a closer look suggests that the decision to convert is fraught with many “what ifs”. Let’s take a look…

A conversion in 2010 will spread taxable income across two years – 2011 and 2012. For example, converting a $1,000,000 IRA in 2010 will yield taxable income of $500,000 in 2011 (with tax due 4/15/2012) and $500,000 in 2012 (with tax due 4/15/2013).

Sounds good, right? – maybe! Remember that, in the absence of any further legislation, 2011 will mark the return of Clinton-era ordinary income tax rates.

Is this a bad thing? – you betcha!

Assume a taxpayer is in the highest marginal income tax bracket of 35%. The $1,000,000 conversion in 2010 (had the income been reportable in the year of conversion) would pay tax of $350,000.

Under the actual conversion rules, half of the income is reported in 2011 and 2012. The highest marginal bracket under the Clinton-era rules is 39.6%. As a result, the taxpayer can expect to pay $396,000 in taxes (or 39.6% of $500,000 in 2011 and again in 2012).

The net result is an additional tax burden of $46,000!

And so we arrive at a bit of a conundrum. On one hand, the Roth IRA has superior benefits. Plus there’s the ability to convert in one year but defer the recognition of income (and subsequent tax payments) into the future. However, this is offset by the higher income tax rates that will be in effect.

The conversion decision is made even more complex by several other factors. For example…

After the conversion, will the tax-free growth in the Roth IRA compensate for not being able to invest the money set aside to pay the tax bill associated with the conversion? Intuitively, the longer the money remains in the Roth IRA after conversion, the more it makes sense to convert. As a result, life expectancy must be considered.

If there’s no intention to take distributions from the Roth IRA during the account owner’s lifetime, will beneficiaries be able to maximize deferral by delaying distribution or will they deplete the account in short order through an aggressive withdrawal strategy? As a result, inter-generational planning must be considered.

Assuming conversion makes sense, where will the money come from to pay the tax bill? It shouldn’t come from the IRA if you’re under the age of 59 1/2. If it does, it will count as a distribution subject to the 10% early withdrawal penalty.

In the end and as always, the decision is case-specific and must be analyzed in the context of the “big picture” as there are steps to be taken (both prior to and after 2010) to plan for and maximize the benefits of a conversion. Want to know if an IRA conversion is right for you? Give us a call and we’ll be happy to discuss it with you.

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