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MONTHLY TAX NEWSLETTER

SHOULD YOU CONVERT TO A ROTH IN 2010?

by Andrew D. Schwartz, CPA

Eight months and counting.  Effective January 1, 2010, the income limitation preventing people from converting their IRAs and other qualified retirement accounts to a Roth IRA disappears.

What makes Roth accounts so attractive?  While you don't get a current year tax deduction for money contributed into a Roth, any money invested within your Roth grows tax-free.  As long as the rules don't change down the road, you'll be able to withdraw money from your Roth upon reaching age 59 1/2, and you won't pay even a dime in taxes on the money withdrawn.

Even though Roth IRAs were first introduced back in 1998, many middle-income and high-income taxpayers have never had the opportunity to contribute money into these tax-free retirement savings accounts.  For 2008, single individuals who earned more than $116k and married couples who earned more than $169k were ineligible.

A second way to get money into a Roth IRA has been even more restrictive.  Since the Roth rules were first instituted eleven years ago, the income threshold to be able to convert your existing IRAs or other qualified retirement accounts to a Roth has been stuck at $100k .  Please note that the same $100k threshold applies to single individuals and to married couples.  (Talk about the marriage penalty.)

One relatively new option available to many taxpayers looking to get some money into a Roth account is to take advantage of the Roth version of an employer sponsored 401(k) or 403(b) Plan.  As I wrote last spring in the April 2008 Newsletter in A Rant About Roths, however, I am not generally a big fan of this strategy for people in the higher tax brackets.  Remember, you are giving up a valuable current year tax break in exchange for a promise from the government that they won't change the rules between today and when you retire.  I don't trust those guys in Washington to keep their word.

Fortunately, there is a more tax efficient strategy available to you to finally get some money into a Roth IRA.  As I wrote in our March 2007 newsletter in The Re-Emergence of the Non-Deductible IRA, you don't give up a current year tax break when you make non-deductible IRA contributions that you subsequently convert to a Roth IRA in 2010.  Depending on what your IRAs are worth versus the non-deductible contributions you made over the years, you could conceivably end up owing no income taxes on the money you convert.  And even if you do have income to report, the rules allow you to spread the income from the 2010 Roth conversion over two tax years.

What steps should you take now in anticipation of converting your IRAs and other eligible retirement accounts to a Roth IRA in 2010?

Check Your Balances

The first step is to see how much you have in your IRA accounts.  Yes, even though the Dow is still way down from it's peak of $14,000, I'm asking you to do the unthinkable and open your statements to tally up the value of all of your IRA accounts.  Don't forget to include all of your traditional IRAs, rollover IRAs, SEP IRAs, and SIMPLE IRA accounts.

Verify Your Non-Deductible Contributions

Next, figure out the total of your non-deductible contributions you've made over the years.  The easiest place to find this number is to pull out your 2008 Form 1040, and take a look at the Form 8606 attached.  This is the IRS tax form used to keep track of your cumulative post-tax IRA contributions.

Don't despair if you haven't submitted a Form 8606 each year or the number reflected on the current year's 8606 is incorrect.  The IRS allows you to file this form as a stand alone form.

Simply enter the correct totals for the non-deductible contributions made through 2008, sign the form on the bottom of page 2, and submit the signed Form 8606 to the Internal Revenue Service where you would otherwise file your Form 1040.  It's very important that the IRS have the correct info on file in anticipation of your converting your IRAs to a Roth IRA in 2010.

Figure the Tax Burden

Here is where things might get a little tricky.  Does it make sense for you to convert your IRAs to a Roth IRA?

If the value of all of your IRA accounts is less than the total of your non-deductible contributions as reflected on your 8606, there is no reason not to convert to a Roth in 2010.   As an added bonus, you can even claim your remaining IRA basis as a miscellaneous itemized deduction provided you convert 100% of your IRAs by the end of the year.

What if your IRAs are worth more than your after-tax contributions?  Expect to pay taxes on the percentage of each dollar converted that represents the pre-tax portion of all of your IRAs. 

For example, let's say your IRAs are worth $60,000, and you made a total of $20,000 of non-deductible contributions over the years.  In this example, there would be $40,000 of pre-tax dollars built into the $60,000 of IRA value, which means two-thirds of each dollar converted would be taxed. 

Basically, the smaller the percentage of post-tax dollars within your IRAs, the tougher this decisionl becomes.  And remember, if you have multiple IRA accounts, you need to determine the pre-tax amounts included within all of those accounts - even if you only ever made your non-deductible contributions into just one IRA account. 

We Can Help

Need help figuring out what to do about this rapidly approaching opportunity?  For starters, work through the 2010 version of our Roth Conversion Quiz which you can find below.

For more info, listen to our podcast about Saving Taxes By Saving For Retirement.  The segment about converting your IRAs to a Roth IRA begins at 48:30.

Still need help?  Please contact the nearest MDTAXES CPAs to help you work through the math and make a prudent decision.

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2010 VERSION OF OUR ROTH IRA CONVERSION QUIZ

When you convert an IRA or other qualified retirement account to a Roth IRA, you take money that is growing tax deferred and turn it into Roth money that grows tax-free.  The downside to converting is that you most likely will owe some taxes on the amount converted.  

For 2009, you're allowed to convert some or all of your traditional IRAs to a Roth IRA only if your income is less than $100,000.  Effective 2010, the income limitation no longer applies, so everyone becomes eligible.

Should you consider converting your IRAs to a Roth IRA?  To help you decide what to do, we've prepared this Roth IRA Conversion Quiz. 

Please answer the following ten questions. When you are done, simply add up your score, and compare your score with the table found at the bottom of this page to determine whether you should consider converting your IRA to a Roth IRA. 

If the value of your IRAs is less than the non-deductible contributions you've made over the years, then don't bother with this quiz.  You will definitely want to convert your IRAs to a Roth IRA early in 2010. 

Question 1: How many years before you anticipate taking distributions from your IRA or Roth IRA?

• More than 20 years (2 points)
  
• 10 - 20 years (4 points)
  
• 5 - 10 years (6 points)
  
• Less than 5 years (8 points)

 
Question 2: At what rates do you think you will pay taxes in the future? (Currently, there are six tax brackets: 10%, 15%, 25%, 28%, 33%, 35%.)

• You will be taxed at a much higher tax rate in the future. (2 points)
  
• You're not sure, but you're fairly certain that your tax rate will NOT decrease in the future. (4 points)
  
• Once you retire, you will be taxed at a lower tax rate. (6 points)
  
• The whole tax system is going to change within your lifetime and you will not pay any income taxes in the future. (8 points)

 
Question 3: How Much Untaxed Money Is Sitting Within Your IRAs?  

• The value of your IRAs exceeds your cumulative post-tax contributions by a very small amount. (2 points)
  
• Your post-tax contributions make up more than half the value of your IRAs. (4 points)
  
• Your IRAs are worth more than double your cumulative non-deductible contributions. (6 points)
  
• Your IRAs include little or no post-tax dollars.  (8 points)

Question 4: How will you pay the taxes that will be due in connection with the conversion? Remember, the taxes on the 2010 conversion will be spread over two years starting in 2011.

• You currently have enough money sitting in a savings account to pay the taxes that will be due. (2 points)
  
• You will be able to adjust your withholding at work to cover the additional taxes that will be due without impacting your family budget too badly. (4 points)
  
• The money needed to pay the taxes is fully invested in stocks and mutual funds. To pay the taxes that will be due, you will need to sell some of those investments. (6 points)
  
• You will not be able to come up with the money to pay the taxes on the conversion without withdrawing money from the Roth IRA. (8 points)

 
Question 5: Do you trust the government not to change the rules as they pertain to Roth IRA's?

• Over your lifetime, the government will not change any of the rules pertaining to Roth IRA's. (2 points)
  
• The rules will change, but amounts contributed to your Roth IRA prior to the date that the rules are changed will be grandfathered and, therefore, not subject to income taxes when withdrawn . (4 points)
  
• While you're hopeful that the rules pertaining to Roth IRA's won't change, you feel that, during your lifetime, distributions from Roth IRA's will be subject to some level of income taxes. (6 points)
  
• There is no way that, during your lifetime, the government will not begin to tax distributions from Roth IRA's. (8 points)

 
Question 6: How do you feel about pre-paying income taxes to the government?

• You're not opposed to pre-paying income taxes today if you can save significant taxes in the future. (2 points)
  
• You'd prefer not to have to pre-pay any income taxes, but the many benefits of the Roth IRA make it acceptable. (4 points)
  
• You have trouble rationalizing pre-paying taxes today; especially when you have no guarantees as to what the tax rules will be like when you begin to withdraw money from your IRA's. (6 points)
  
• You only pay taxes to the government when you're absolutely required to pay them and would never even consider pre-paying as little as one dime in taxes to the government. (8 points)

 
Question 7: At what age will you begin to withdraw money from your IRA or Roth IRA?

• You plan to wait as long as possible before taking any distributions from your IRA or Roth IRA to maximize the tax deferred growth. (2 points)
  
• You won't need the money when you retire, but you view the money in your IRA or Roth IRA as your savings and you plan to spend some of it during your lifetime. (4 points)
  
• You will retire with a moderate amount of savings, but will PROBABLY need to begin taking withdrawals from your IRA's around the time you turn 70. (6 points)
  
• You will have few assets in addition to your IRA's when you retire, so you will DEFINITELY begin taking distributions from your IRA or Roth IRA before reaching the age of 70. (8 points)

Question 8: How do you feel about your heirs paying income taxes on the balance in your IRA's and Roth IRA's that they will eventually inherit?

• You'll do whatever it takes to minimize the taxes that your heirs will pay on amounts that they inherit from you. (2 points)
  
• You'd be willing to pay some taxes now to have your heirs avoid being subject to income taxes on the IRA's and Roth IRA's that they inherit. (4 points)
  
• You would regret if your heirs had to pay a lot of taxes on their inheritance, but you wouldn't be so upset that you would consider paying some taxes in advance. (6 points)
  
• The fact that your heirs might be subject to income taxes on the IRA's that they inherit doesn't bother you in the least. (8 points)

Question 9: How do you feel about the long-terms prospect of your IRA investment portfolio?

• You're confident that the stock markets will ultimately get back on track and return to their historical growth rates of more than 10 percent per year. (2 points)
  
• You don't think we'll ever see growth like we saw during the previous 20 years, but feel that you can come up with a diversified portfolio that will get you a decent return. (4 points)
  
• You've become risk adverse and will invest only in very conservative investments. (6 points)
  
• You feel that the markets are still overvalued and will continue to go down in value in the short-term, and aren't worried that Obama will do away with this strategy after 2010. (8 points)

Question 10: How do you feel about withdrawing money from your IRA's for education costs, medical expenses, or other uses?

• You view money in your IRA's as available to be used in a financial emergency (excluding education or medical expenses) and would reluctantly withdraw money from your IRA's if a cash crisis were to arise. (2 points)
  
• You would not even consider invading your IRA's prior to your retirement. (4 points)
  
• You have a tendency to spend every dime available to you and would most likely end up withdrawing money from you IRA's UNLESS the amounts withdrawn were subject to income taxes and the 10% premature distribution penalty. (6 points)
  
• In the future, you intend to use the money in your IRA's to pay for your family's education or medical expenses since there won't be any other source of money available to you at that time. (8 points)

The Results

Total up the points from each question. If your score is:

• Less than 30, you should DEFINITELY consider converting your IRA to a Roth IRA in 2010.
  
• Between 31 and 42, you should PROBABLY consider converting your IRA to a Roth IRA.
  
• Between 43 and 48, you have a TOUGH DECISION to make.
  
• Between 49 and 60, you should PROBABLY NOT consider converting your IRA to a Roth IRA.
  
• Greater than 60, you should DEFINITELY NOT consider converting your IRA to a Roth IRA.

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TAX AND FINANCIAL PLANNING CALENDAR FOR MAY, 2009

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2008 & 2009 TAX FACTS

• For 2008, the standard deduction for a single individual is $5,450 and for a married couple is $10,900. A person will benefit by itemizing once allowable deductions exceed the applicable standard deduction. Itemized deductions include state and local income taxes (or sales taxes), real estate taxes, mortgage interest, charitable contributions, and unreimbursed employee business expenses.
• For 2008, the personal exemption is $3,500. Individuals will claim a personal deduction for themselves, their spouse, and their dependents. 
  
• The maximum earnings subject to social security taxes is $106,800 for 2009, up from $102,000 for 2008.
  
• The standard mileage rate is $.55 per business mile as of January 1, 2009, down from $.585 per mile as of December 31, 2008.
  
• The maximum annual contribution into a 401(k) plan or a 403(b) plan is $16,500 in 2009.  And if you'll be 50 or older by December 31st, you can contribute an extra $5,500 into your 401(k) or 403(b) account this year.
• The maximum annual contribution to your IRA is $5,000 for 2008 and 2009.  And if you turn 50 by December 31st, you can contribute an extra $1,000 that year.  You have until April 15, 2009 to make your 2008 IRA contributions. 

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