by Brian Hufford, CPA, CFP
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When first introduced, the Roth IRA promised to be the ultimate retirement savings concept. The idea of tax–free growth and tax–free distribution at retirement seemed too good to be true. Most dentists have been unable to benefit from Roth IRAs because of the $100,000–income limit in converting regular IRAs to Roth IRAs that exists through 2009. If a dentist has annual family income for 2009 in excess of $100,000, he or she cannot convert a regular taxable IRA to a nontaxable Roth IRA.
Likewise, many dentists could not establish a new Roth IRA because of additional income limits based on modified adjusted gross income, which is $176,000 for married filers in 2009. Through 2009, there is a limit for converting regular IRAs to Roths, as well as an income limit to establish a new Roth IRA.
It is time to reevaluate Roth IRAs for 2010. Under the Tax Increase Prevention Act enacted in 2006, Congress permanently eliminated the $100,000 income limit for Roth conversions, effective Jan. 1, 2010. While the income limit for establishing new Roth IRAs will still be in place, the limit for converting is eliminated. With tax rates scheduled to rise dramatically in 2011 under the current administration and with market losses realized in the past year, now might be a perfect time to convert some or all IRAs to Roths. Following are some of the issues that you will need to consider.
Suppose you have $60,000 sitting around in regular IRAs from various sources. Some of the IRAs are spousal rollovers from qualified retirement plans, while some are deductible IRAs from early savings, and some are nondeductible IRAs used to supplement savings in qualified retirement plans.
Let's assume that of the $60,000 total market value in the various IRA accounts, $15,000 represents the nondeductible IRA contributions over the years. If you were to convert the $60,000 to Roth IRAs, what happens from an income tax standpoint in 2010 — the year of conversion? As expected, income tax laws create some complexity with this decision.
The law does not require that you convert all IRAs to Roths, so why not simply start by converting the non–deductible IRAs? Suppose the nondeductible IRA has a value of $20,000 with nondeductible contributions of $15,000. If you were allowed expected tax treatment on this nondeductible IRA in conversion to a Roth, wouldn't this mean that you would only pay tax on $20,000 minus $15,000 or $5,000?
No, the IRS says. The IRS requires that you follow a pro rata rule, which forces you to divide the $15,000 nondeductible contributions by the total value of all IRA accounts — $60,000 in determining your tax basis — even though you are only converting a nondeductible IRA account. By dividing $15,000 by $60,000, only 25% of the $20,000 — $5,000 — would be nontaxable and the balance would be taxed upon conversion.
Other complexities exist, too. Since the law does not require that all IRAs be converted at once, the decision to convert all or some becomes an exercise of forecasting future tax brackets and future investment results. Suppose, in our example, that the decision was made to convert all $60,000 of IRAs to Roths in 2010. You could report $60,000 minus $15,000 — $45,000 — of Roth–conversion income on your 2010 return. Or you could elect under a special provision for 2010 to spread the income equally between the years 2011 and 2012 — $27,500 each year.
This requires some complex forecasting with the proposed higher tax rates in later years. An important item for your planning: We believe that it is important for you to have sufficient savings outside of IRA accounts to pay the income taxes upon conversion. Any withdrawals from IRA accounts prior to age 59½ to pay taxes would be subject to the 10% withdrawal penalty and would likely negate hoped–for benefits.
For older IRA holders, there are other issues to consider. Roth IRAs have favorable estate tax implications, while regular IRAs do not. But if an IRA holder is receiving required minimum distributions after age 70½, then the law does not allow a conversion to a Roth until the required minimum distribution for the current year is made. For 2009, Congress has given a holiday for required minimum distributions, but those return in 2010.
For many dentists, a conversion to a Roth IRA in 2010 could be attractive. Make sure that you receive adequate planning help from your tax advisor to ensure that you have considered all planning aspects related to the conversion.
Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee–only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470–3064, or [email protected].