Year of the Conversion

If you grew up in my generation, you probably remember Al Stewart’s 1976 hit, “Year of the Cat” from his platinum album with the same name. Well, 34 years later (boy, am I getting old!), 2010 is being dubbed by the financial community as the “Year of the Conversion” in reference to the removal of the income threshold in connection with Roth IRA conversions.

Although the Roth IRA and the Roth IRA conversion technique were both established by the Taxpayer Relief Act of 1997 for taxable years beginning in 1998, like a lot of tax legislation that provides for potentially favorable benefits, the ability to  take advantage of the latter until now has been dependent on one’s income level. From 1998 through 2009, only taxpayers with modified adjusted gross income of less than $100,000 were eligible to convert a traditional IRA to a Roth IRA.

It wasn’t until January 1st of this year that the $100,000 income threshold was eliminated as a result of the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005. Now anyone who has a traditional IRA can convert part or all of his/her accounts to one or more Roth IRA accounts.

What’s So Special About a Roth IRA?

Like a traditional IRA, Roth IRA’s enjoy tax-exempt growth. So long as you don’t take any withdrawals from either a regular or Roth IRA, you won’t pay income taxes on the income earned. This includes interest, dividends, and realized gains from securities sales. Unlike a traditional IRA to which you may make potentially deductible contributions depending on your income, contributions to a Roth IRA aren’t deductible.

So if contributions aren’t deductible and you receive the same tax-exempt growth as a traditional IRA, why do a Roth IRA? There are two main attractions of a Roth IRA that aren’t available to traditional IRA owners:

  1. Nontaxable distributions
  2. No required minimum distributions (“RMD’s”)

Nontaxable Distributions

Whenever a deduction is allowed for contributions to a retirement plan, whether it be an IRA, 401(k), or some other type of pension plan, withdrawals from the plan are taxable as ordinary income just like salary. Since contributions to a Roth IRA aren’t deductible, withdrawals generally aren’t taxable.

There is, however, an important exception to this rule. Any distributions, with limited exceptions that are beyond the scope of this blog post, that aren’t attributable to non-deductible IRA contributions will be taxable as ordinary income if they are taken before the later of (a) five years after the Roth IRA owner established and funded his or her first Roth IRA account or, in the case of a Roth IRA conversion, five years from the date of the conversion, or (b) age 59-1/2. In addition, if the distribution is from a Roth IRA conversion and you are less than 59-1/2 when you take your distribution, it is also subject to a 10% premature distribution penalty.

No Required Minimum Distributions (“RMD’s”)

Whereas contributions to traditional IRA’s are potentially deductible and the accounts also enjoy tax-exempt growth until you begin taxing withdrawals from them, IRS doesn’t allow this nirvana to continue indefinitely. Once you turn 70-1/2, you must begin taking annual required minimum distributions, or “RMD’s,” from your traditional IRA based on the value of your IRA accounts at the end of the previous year using a life expectancy factor from an IRS table. A 50% penalty is assessed on the amount of any RMD’s not distributed.

Roth IRA’s are not subject to the RMD rules during the owner’s lifetime. You can convert 100% of a traditional IRA to a Roth IRA at age 25 and not take any distributions from it for the duration of your life without being exposed to any penalties. Once again, IRS doesn’t allow this benefit to continue indefinitely. Roth IRA’s are subject to RMD’s after the death of the owner. Therefore, if you inherit a Roth IRA, you will be required to take minimum distributions from it.

As you can see, even though we’re in the midst of the “Year of the Conversion,” the two main attractions of a Roth IRA are not bullet-proof. With this in mind, should you convert your traditional IRA to a Roth IRA? Hmm, sounds like an idea for another blog post!