There is still time to take advantage of a new estate planning opportunity if you currently own a traditional individual retirement account or other qualified retirement plan (“IRA”) and want to convert some or all of your IRA to a Roth IRA, but were reluctant to do so because of the immediate income tax liability that would be associated with the conversion or were prohibited from converting in the past because you earned too much income. With some planning, your IRA can be converted and left for your heirs while also providing them with tax-free income for years to come.

Under prior law, a traditional IRA could be converted to a Roth IRA only when the account owner’s modified adjusted gross income was $100,000 or less. Beginning in 2010, the income limit no longer applies. Thus, all individuals are now entitled to convert a traditional IRA to a Roth IRA. If you convert, you generally must include the conversion amount in your gross income in the year of the conversion. However, if you convert in 2010, you are eligible to pay one-half of the taxes related to the converted amount in 2011 and the other half in 2012.

Traditional IRA vs. Roth IRA.

With a traditional IRA, you make contributions with “pre-tax” dollars, and your investment is allowed to grow on a tax-deferred basis; that is, amounts earned, including the contributions, earnings and appreciation, are not taxed until distributions are made. Traditional IRAs are subject to mandatory distribution requirements when the account owner attains age 70½, also known as “required minimum distributions” or RMDs. The forced distributions result in income tax to the account owner each year after attaining age 70½, while continuously diminishing the tax-deferred amount remaining in the account (subject to offsetting earnings and growth).

By contrast, contributions to Roth IRAs are made with “after-tax” dollars and, as a result, the appreciation inside a Roth account grows tax-free. Therefore, there is no income tax when money is distributed from a Roth account in retirement or when distributions are made to the account owner or the beneficiaries. In addition, Roth IRAs are not subject to RMDs when the account owner attains age 70½. Consequently, if the account owner converts a traditional IRA to a Roth IRA, he or she will not be required to take RMDs during life. After death, a beneficiary receiving a Roth account will be required to take RMDs over his or her life expectancy. However, unlike a traditional IRA, distributions received by beneficiaries from an inherited Roth IRA will not be subject to income tax when received. Thus, after death, the heirs, if they wish, will be able to keep utilizing the Roth IRA as a “tax shelter” and obtain tax-free growth within the IRA during their lifetimes and not pay any income tax on the RMDs that they receive each year over their lifetimes.

Benefits of Roth IRA Conversions.

Even though you are still responsible for the income taxes related to a conversion, there are significant tax benefits which can be achieved through a conversion which may be well worth the cost of paying the income tax currently rather than over time. If it is likely that you will not need the income from your IRA during retirement, a 2010 Roth conversion will offer you the following benefits: (1) suspends the lifetime RMD rules applicable to you allowing for continued tax-free growth in the account over your lifetime; (2) paying the income tax now, thereby effectively reducing your overall taxable estate, (3) allows you to stretch out the income tax due over a period of two extra years; and, most importantly, (4) transfers wealth to lower generations that can continue to grow free of income tax for many years into the future.

If you have not recently updated your estate plan or considered the strategies discussed in this article, we encourage you to call us.

Jeffrey C. Rambach
918-591-5202
jrambach@dsda.com