A Happy Ending For Your Depressed IRA?

By Kurt Ohliger, Jr., CPA (Nov, 2009)

Does the depressed value of your Individual Retirement Account (IRA) have you, well, depressed? Are you worried about individual tax rates skyrocketing? 2010 offers a first time opportunity for many taxpayers to bring their traditional IRAs to a happy ending by converting them to a Roth IRA.

Beginning January 1, 2010, all taxpayers, regardless of their "modified adjusted gross income" (MAGI) and/or filing status will be able to convert traditional IRAs into Roth IRAs. Currently, only taxpayers with MAGI of less than $100,000, and whose filing status is anything other than "married filing separate" can convert a traditional IRA, including SEP IRAs and SIMPLE IRAs, to a Roth IRA. For 2010 (and beyond under current law), those restrictions have been eliminated.

As a result of the stock market meltdown from October 2007 through 2008, many taxpayers saw the values of the traditional IRAs plummet, losing upwards of fifty percent of their value. Although recent months have shown some positive trends, your IRA value is probably still below its pre-October 2007 levels. Current economic conditions have the federal, state and local governments starving for revenue. The professional thinking is an increase in tax rates is on the horizon.

Why convert your traditional IRA to a Roth IRA?

A Roth IRA has two advantages over traditional IRAs. First, unlike withdrawals from traditional IRAs, qualifying withdrawals from Roth IRAs are tax free for Federal and most state tax purposes. Qualifying withdrawals are those distributions the taxpayer takes after their Roth IRA has been open for over five years and they have reached the age of 59 ½. A Roth IRA is deemed to be opened on the first day of the tax year (i.e. January 1st for individual taxpayers) in which the initial contribution is made. Initial contributions can be in the form of regular annual contributions or conversion contributions. The second advantage of a Roth IRA is that a taxpayer is not required to take a "required minimum distribution" (RMD) after reaching age 70 ½. Therefore, the investments can hopefully continue to grow tax free to be distributed when needed, or passed on to beneficiaries in the event of the taxpayer's death.

The Conversion Process

There are three methods to be used to convert a traditional IRA to a Roth IRA. First, a distribution from a traditional IRA can be "rolled over" to a Roth IRA within 60 days of the distribution. Second, a "trustee-to-trustee" transfer of the value of the traditional IRA can be arranged. Finally, the same trustee can simply transfer the amount from a traditional IRA to a Roth IRA. In all likelihood, this third option will be the most practical since this method will allow the taxpayer to keep the same investments within the IRA rather than liquidating a portfolio and reinvesting funds.

The conversion does not have to be an "all-or-nothing" event. If a taxpayer has multiple IRAs, they can choose to convert some and not others. In addition, partial conversions of a single IRA are permitted. The traditional IRA that includes both deductible and nondeductible contributions is also eligible for conversion. Even if a taxpayer has reached age 70 ½, their traditional IRA is still eligible for conversion. However, the RMD amount for the year of conversion must be subtracted from the account balance that is otherwise eligible for conversion.

Tax Implications of conversion

By now you must be wondering "Okay, what is the catch?" The catch is that the conversion will generally trigger a taxable event because the taxpayer is treated as receiving the converted amount as a distribution from the traditional IRA, followed by a contribution into the Roth IRA. This is true even if there is no actual distribution or contribution, for example, because the trustee simply transferred the amount to a Roth IRA. However, due to the depressed value of the traditional IRA, the tax cost of conversion is at or near its low point. Lower values, combined with the possibility of higher tax rates in the near future, provide the best opportunity to shelter the future income and gains generated in the Roth IRA as the economy begins to recover as we all expect it will.

For conversions that occur in 2010, the taxpayer has the option of electing for federal tax purposes only to "spread" the income triggered by the conversion over two years, 2011 and 2012. For conversions occurring on January 2, 2010, an electing taxpayer could defer one-half of the federal taxes until April 15, 2012 (the due date of their 2011 tax return) and defer the remaining half until April 15, 2013 (the due date of their 2012 tax return). The level of the taxpayer's income and tax rates applicable to tax years 2011 and 2012 could impact the decision to elect the deferral option.

The IRS has also included an "oops" option to allow so called "ill-fated" conversions to be reversed. For 2010 conversions taxpayers will have until October 15, 2011 to reverse their conversions, essentially keeping their traditional IRA as if the conversion never occurred. Therefore, if you convert your traditional IRA in early 2010, and the investment value continues to decline, you will effectively pay tax on value you no longer have. In this case, the IRS will allow you to re-characterize the converted amount back to a traditional IRA.

What to do next?

As with any tax planning, the analysis of whether a conversion is appropriate depends on a number of taxpayer-specific facts and circumstances. To learn more about converting your traditional IRA to a Roth IRA and whether it is prudent given your own individual tax scenario, please contact your DB&B tax advisor today.


The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.

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