John M. Hoffman CPA

Favorite Tax Planning Ideas

ROTH IRA conversions - 2010 and forward (still love this in 2015)

This is an interesting idea and for many taxpayers presents a great opportunity. In 2010 the income limit for converting a regular IRA to a ROTH IRA will be lifted. This means that people who had previously been excluded (due to high income ) from contributing to a ROTH IRA or converting a traditional IRA to a ROTH IRA now have a chance through conversion.

When a traditional IRA is converted to a ROTH IRA, the traditional IRA is treated as having been distributed and the taxable amount from that IRA is included as taxable income. For many people this is not too exciting because most people in higher tax brackets would not want to convert their traditional IRAs to ROTH IRAs, paying the tax on the conversion today in exchange for the income from the ROTH later on in life to be tax free.

What if the tax on the conversion was not very much, even if you have high income? You may wonder how that may work. Many people have made non-deductible contributions to their IRAs over the years and effectively built up basis in their IRA (as tracked on form 8606). If that IRA dropped in value with the 2008 / 2009 economic meltdown, perhaps there is little taxable gain in that IRA today. That would mean a conversion of that IRA to a ROTH IRA would be at little or no tax cost and one would get the lifetime of earnings to be tax free.

The ideal situation is to either have a high percentage of "basis" in your IRA, or perhaps to have no IRA at all. Many wealthy taxpayers have all of their retirement savings at their company 401(k) plan.

Let's address the person with a high percentage of basis in their IRA. Let's assume that a person's only IRA is one that has lifetime non-deductible contributions (as tracked on form 8606) of $40,000. At it's peak the IRA was worth $75,000 but has since dropped to $50,000. That means that there is only $10,000 of taxable income in that IRA. That means that as of January 1, 2010, that person could do a ROTH conversion and only have to include $10,000 in their taxable income. Let's say that tax on that $10,000 is 30% or $3,000. The benefit of doing this is that the $50,000 goes into an account that can grow free of tax. Let's say that the account grows at 5% per year and has 30 years to grow. That account would grow to be worth $200,000 and all of that income would be free of tax. If that were left in the traditional IRA the current $10,000 of taxable income and the future growth of $150,000 or a total of $160,000 would ultimately be taxable. I would certainly be willing to pay $3,000 today to cleanse the tax treatment of not only the $10,000 that is taxable but all future income on the $50,000.

In this situation I would suggest that the taxpayer add the 2009 and 2010 contributions (let's assume that it is $5,000 each year and not deductible), making the conversion $60,000, and that taxpayer, irrespective of their level of income was able to get their 2009 and 2010 IRAS into a ROTH account while converting their old account.

Let's look at the other situation of someone who does not have an IRA, who might have a 401(k) at work, and earns too much for an IRA contribution to be deductible. On January 2, 2010, that taxpayer makes their 2009 IRA contribution and their 2010 IRA contribution. On January 3, 2010 that taxpayer converts that IRA to a ROTH. The amount of income from the conversion is the income from that one day (January 2).

Many people are concerned about not being able to save enough for their retirement as well as what future tax rates will be. Getting money into a ROTH IRA can help address both concerns.

As always, if you would like to discuss how this might be applicable to you, please contact our office.