By Noah B. Rosenfarb CPA, ABV, PFS, CDFA
The intent of this article is to educate the reader about increasing retirement income by converting traditional retirement plans (401k, IRA, 403(b), etc.) to a Roth IRA. While conversions (commonly referred to as “recharacterizations”) can be beneficial to many taxpayers, there is a unique opportunity that often arises in the year of a divorce because of the timing of alimony payments.
What are Roth IRAs?
The Taxpayer Relief Act of 1997 created a new type of Individual Retirement Account (“IRA”) named after Senate Finance Committee Chairman, Senator William V. Roth, Jr. Roth IRAs offer an unparalleled tax incentive – while contributions to Roth IRAs are not tax-deductible (unlike traditional IRAs), all distributions from a Roth IRA are tax-free.
What are the Advantages?
Similar to traditional IRAs, the dividends and interest generated by a Roth IRA, are not taxed while they are accumulated in the IRA. However, Roth IRAs offer a significant bonus – tax-free withdrawals. Although contributions are not tax deductible, withdrawals at age 59½ (earlier if you use it to buy a first home) are tax-free as long as it has been in the account for at least five years. And, there is no requirement to withdraw any money at age 70½; and, upon death, beneficiaries will not owe any income taxes upon withdrawal.
Facts on Converting Traditional IRAs to a Roth IRA
You can convert all or part of your traditional IRA to a Roth IRA as long as your adjusted gross income does not exceed $100,000. However, taxpayers in the “married filing separately” category are NOT permitted to convert to a Roth IRA. There is no 10% early withdrawal penalty on your traditional IRA when you convert it to a Roth IRA. However, because contributions to a Roth IRA are non-deductible, you must pay tax on any taxable amounts you convert.
Eligibility is determined by adjusted gross income in the conversion year. The dollar amount of the conversion is NOT considered part of the adjusted gross income for purposes of determining eligibility. The conversion is treated as a penalty-free premature distribution. Therefore, it must be listed on your tax return for the year as taxable income, and that could move you into a higher tax bracket.
For 2010 there is a change in the tax code that eliminates the adjusted gross income limit for conversion. Also, conversions made in 2010 can spread the resulting “reportable income” over the following two years, including the income equally in 2011 and 2012, although, one can choose to report 100% of the resulting income in 2010.
Signs for a Conversion Candidate
While there are no hard and fast rules to identify conversion candidates, here are some “signs” to look for:
- Income for the taxpayer will be “artificially” lower in the year of divorce than in future years. Look for alimony beginning late in the year to signal an opportunity.
- The taxpayer will have assets outside of the retirement plan to pay taxes. If this is the case, the taxpayer is essentially making an additional contribution to their retirement savings.
- The younger you are, the more time you have to accumulate earnings to take out tax-free at retirement. However, not all young taxpayers should convert, and conversions can make sense for older taxpayers.
- If you expect to be in a higher tax bracket when you retire than you are at the point of conversion, it is better to convert while in a lower tax bracket and pay the lower tax rate.
There are certain on-line conversion calculators that allow you to input various information (age, current tax rate, expected retirement tax rate, expected returns on assets, etc.) to help evaluate if a conversion would create more after-tax retirement income. Type “Roth IRA Conversion” into a search engine to find examples, or type any of the following into your web browser:
While conversion calculators are helpful, the decision on whether to convert or not should be discussed with a financial planner and/or accountant, as there are other variable that should be discussed when making a determination. |
