September 13, 2010
Problems with Roth IRA Conversions
Christopher R. Hoyt (Professor of Law, University of Missouri--Kansas City School of Law) recently published his article entitled Rethinking Roth IRA Conversions in 2010, 24 Prob. & Prop. 12 (Sept.-Oct. 2010). An excerpt from the introduction is below:
High-income taxpayers have been able to contribute to a Roth 401(k) or a Roth 403(b) account if an employer offered such an option, but contributions to a Roth IRA had been off limits to them until 2010. By way of background, money can get into a Roth IRA in two ways. The first is a “regular contribution” of up to $5,000 per year ($6,000 if over age 49) made by a person who has wage or self-employment income. But if a person’s adjusted gross income in 2010 is over $120,000 ($177,000 on a joint return), he or she is prohibited from making such a contribution to a Roth IRA. IRS Notice 2009-94, 2009-50 I.R.B. 848. Thus, the only way a high-income taxpayer canhave a Roth IRA is the second way: by making a Roth IRA conversion.
A Roth IRA conversion is a transfer of assets from a traditional IRA or other qualified retirement account into a Roth IRA. Until 2010, a Roth IRA conversion was prohibited if an individual had over $100,000 of “modified adjusted gross income,” but that limit was eliminated in 2010. IRC § 408(c)(3) (B) (2009).
The main tax challenge is that a Roth IRA conversion is a taxable event. A conversion is treated as a taxable distribution from the traditional account followed by a nondeductible contribution to a Roth IRA. IRC § 408A(d) (3)(A)(i) & (ii); Treas. Reg. § 1.408A-4, Q&A-1(c) & Q&A-7. A special provision permits a taxpayer to defer the taxation of a 2010 Roth IRA conversion into the years 2011 and 2012. IRC § 408A(d)(3)(A)(iii). Many taxpayers, though, have stated that they prefer to take the tax hit in 2010 because of the relative certainty of lower income tax rates in 2010. If in hindsight a Roth IRA conversion appears to have been a bad decision, an important option is that a person can completely undo a Roth IRA conversion with a “recharacterization” (described below) by transferring the converted amount (plus the allocable investment income) to a traditional IRA.
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