Roth IRAs (“Roth”) have been out of reach for many taxpayers because of income limitations imposed by the IRS. These same taxpayers have also been denied the ability to convert a Traditional IRA to a Roth IRA by a separate, but similar, income restriction. But the rules regarding conversion changed over time. Having the option to convert to a Roth may prove to be very desirable if you are a high income earner. It may also appeal to you if you have existing traditional IRA’s or qualified plan balances. Do you fall into either category?

Q1: What is a Roth IRA?

A1: Roth IRA’s were established by the Taxpayer Relief Act of 1997 and were made available to individual taxpayers in 1998. A Roth IRA allows taxpayers to create an IRA that is funded with non-deductible contributions. Roth IRA’s grow tax-deferred, and if basic requirements are met, distributions from the Roth IRA will be tax-free.

Q2: Are there income limitations for contributing to a Roth IRA?

A2: Yes. In order to contribute to a Roth IRA in 2012 there is still a Modified Adjusted Gross Income (MAGI) limitation. For 2012, the phase-out ranges are $110,000 to $125,000 for singles and $173,000 to $183,000 for married couples filing jointly.

Q3: If I complete a conversion, is the converted amount included in my MAGI?

A3: No. The amount converted does not impact the calculation of MAGI. In fact, you can convert to a Roth IRA even if you have no earned income. Note, however, that the conversion amount does impact the calculation for Adjusted Gross Income (“AGI”).

Q4: Is the conversion rule applicable only to Traditional IRAs or are there other types of accounts that can be converted to a Roth IRA?

A4: You can convert to a Roth IRA from a Traditional IRA, SEP-IRA or SIMPLE IRA (generally after 2 years of participation), 403(b) plan, 457 plan, and a qualified employer plan (such as a 401(k)/Profit Sharing Plan).

Q5: If I’m still employed and still covered under my employer’s qualified plan, can I convert part or all of my employer’s qualified plan balance?

A5: Generally, no. A triggering event (i.e. Retirement, Termination, etc.) would have to occur before a distribution could be made. However, if you are over the age of 59 ½, there may be an opportunity depending upon the type of plan under which you are covered. A distribution from a 401k or profit sharing plan to an active employee over the age of 59 ½ is generally permissible under the law, provided that the plan allows for such distributions. However, most plans don’t have this option. In addition, a 401(k) plan is generally prohibited from making any non-hardship distribution until the employee actually separates service from the employer.

Q6: If I convert to a Roth IRA and then my investments in that account go down, is there any way to reverse the conversion so I don’t pay taxes on higher values that are no longer there?

A6: Yes. This is called a “recharacterization.” Recharacterizations allow you to reverse the conversion as if you never did it. The rules around this are complex. Note that you have until October 15^th of the year following the year you did the conversion to re-characterize it back to a traditional IRA.

Q7: If I re-characterize a Roth conversion, can I then RE-re-characterize it back to a Roth IRA?

A7: The answer is yes, but not in the same tax year. You must wait at least 30 days from the time you re-characterize back to a traditional IRA, and it can’t be any earlier than January 1 of the next year. For example, you convert a traditional IRA to a Roth IRA on September 1, 2012. Five months later your investments have dropped 25%. You can re-characterize the IRA as late as October 15, 2013. However, you won’t be able to convert this re-characterization back to a Roth until January 1, 2014.

Q8: Are there any other reasons besides market losses where I would consider a re-characterization?

A8: Yes. The following possibilities may cause you to consider re-characterization:

(a) you were counting on extra funds to be available to pay the taxes but they are not there;

(b) the added income of the conversion could disqualify a child from receiving college financial aid;

(c) an investment opportunity arose and you want the tax money back for that purpose; and/or

(d) an emergency occurs where the funds used to pay the taxes could now help.

Essentially, there are a number of possibilities where a re-characterization may prove helpful or even necessary.

Q9: What are the basic differences between AGI and MAGI?

A9: MAGI is derived from AGI. You would first calculate your AGI and then perform the required calculations as set forth on pages 2-3 of IRS Form 8606. http://www.irs.gov/pub/irs-pdf/i8606.pdf.

Q10: Can I convert an inherited IRA to a Roth IRA?

A10: No, unless you are the decedent’s spouse. However, if you are a beneficiary of a non-spouse’s qualified plan, you may be able to convert the inherited retirement plan assets directly to a Roth (see Q11).

Q11: I am the beneficiary of my uncle’s qualified retirement plan. If he were to pass away, could I convert the inherited retirement plan assets to a Roth IRA?

A11: Generally yes. Non-spouse beneficiaries can convert directly to a Roth IRA. There are other restrictions and rules, discussed below.

Q12. If I want to convert qualified plan balances that I inherit from a non-spouse, what should I be aware of?

A12: The Plan document must have a provision written into it that actually allows the conversion. If it doesn’t, then you will be forced to roll the qualified plan assets to a Traditional IRA first. Unfortunately, in that case, the conversion option will be lost because under current law, the conversion can only happen if it is a direct transfer (a/k/a “trustee-to-trustee” transfer) from the qualified plan. If you actually receive the distribution and then attempt to invoke the 60-day rollover rule, you won’t be able to roll those assets anywhere, let alone a Roth. You will have to pay taxes and possibly penalties on the amount received and you will have lost any opportunities to keep the account as any type of IRA. The law is very strict here. Barring a change in the law, your best chance if the Plan does not allow for this is to wait to see if either the Plan will be amended or if the law changes.

Q13: We currently file our income tax return as “Married, filing separately.” Will we be able to convert a traditional IRA to a Roth in 2012?

A13: Yes. Prior to 2010, married taxpayers who filed separately were not permitted to convert to a Roth IRA regardless of income.

Q14: Is there a “best time” to convert to a Roth?

A14: That would depend on your specific situation. If you want to lock-in your conversion now because of what you feel are depressed asset values, then it may make sense to convert to a Roth IRA. Additionally, if you convert early in the year and your assets drop significantly in value during the year, then you could re-characterize those assets back to a traditional IRA later in the year. A good time for that re- characterization may be around November of a given year so that if you wanted to then re-re-characterize back to a Roth IRA, you would only have to wait to January 1^st of the following year. Also, you would probably have a good idea by then if there are any changes in the tax laws pending.

Q15: If I convert qualified plan assets to a Roth, whether they are my own or I inherited them, can I convert them into an existing Roth IRA that I have already established for myself? Does that make sense?

A15: You can do that but it may make more sense to create a separate Roth for these assets. A separate Roth IRA for qualified plan assets should make it easier to identify assets that came from particular sources. It should also prove to be less confusing if any questions regarding distributions arise. It may also give you greater distribution flexibility. In addition, if you are under age 59 ½ or aren’t disabled, it probably makes more sense to open a separate Roth IRA for each conversion you do (see next question).

Q16: After I convert to a Roth, how soon can I access the funds without penalty?

A16: The rules are different with conversions than they are with contributions. In general, for a Roth IRA that holds only contributions and investment income, you can always get your contributions distributed to you without tax or penalty (first in, first out). In order to access the earnings income tax-free and penalty tax-free, the Roth IRA must be at least 5 years old and you must be age 59 ½ or older (or disabled). Note that even if you have a Roth 401(k) and no other Roth account, the 5-year holding period doesn’t begin until a Roth IRA is established. With distributions from conversions, however, unless you are over age 59 ½, and the converted Roth IRA is over 5 years old, then you would pay a 10% penalty on the distribution – even though the distribution is not included in gross income. You may pay income taxes, as well, if part of the distribution consists of any gain. Essentially, each conversion creates its own 5-year window and thus must be treated separately from a traditional Roth IRA funded with just contributions.

Q17: I have a traditional IRA that has tax-deductible contributions and also post-tax contributions. I would like to convert just the post-tax portion to a Roth IRA. Can I do that?

A17: Unfortunately, no. The IRS says that you must consider the entire IRA for purposes of the tax effect of the conversion. For example, let’s suppose that your traditional IRA has a total balance of $100,000. Of that, $20,000 is from post-tax contributions and the balance is from tax-deductible contributions and investment gains. If you converted the $20,000 portion because you thought you could, the rules state that the conversion would be considered 20% tax-free ($20,000 divided by $100,000) and 80% taxable. In this case, you would have to report $16,000 of taxable income (80% of the $20,000 conversion).

Q18: Assume the same facts as the previous question but that I have 2 separate IRA’s: one IRA that was funded only with post-tax contributions and one IRA that was funded only with tax-deductible contributions. Can I convert just the post-tax IRA to a Roth IRA?

A18: Again, you cannot. You must look at all IRA balances – deductible and non-deductible – for determining the amount that you must include in taxation. So, even if the non-deductible IRA had exactly $20,000 (your contribution) and no investment gain, you still couldn’t convert that IRA only and escape income taxation. You would still have to report $16,000 of taxable income.

Q19: If I do take a distribution from a Roth IRA prior to the 5-year period, and if that Roth IRA holds converted amounts as well as original contributions and investment gains, is there any way I can avoid having to pay taxes or penalties on a distribution?

A19: Yes, but it depends on your age and the amount of the distribution you take. Distributions from a Roth IRA come first from contributions, then from conversion amounts, and finally from investment earnings. Let’s look at an example. In 2004, at the age of 35, you opened a Roth IRA with regular contributions. You proceeded to make contributions fairly regularly over the years. In 2012 you convert an existing traditional IRA worth $50,000 to a Roth IRA and you commingle it with your existing Roth IRA. In 2016, at age 47, your Roth IRA balance is $100,000 and is comprised of $25,000 of contributions, $50,000 of conversions, and $25,000 of investment gain. At that time you wish to take out $35,000 from the Roth IRA. What taxes would be due? First, there would be no income tax due. That is the result of the ordering process of how distributions are treated. The first $25,000 is a return of your contributions (no income taxes because contributions are made with after-tax dollars), and the next $10,000 is a return of your converted amount (also no income taxes because you paid income tax on the conversion). But, since the converted amount began its own 5-year window in 2013, and since 2016 is only 3 years after conversion, any amount taken from the conversion is subject to a 10% penalty tax (but no income taxes). So, even though you are taking a distribution of money that isn’t included as income, you are still going to pay a penalty because you are under age 59 ½ and because the converted amount isn’t at least 5 years old.

Q20: I’m over age 70 ½ and have already begun taking required minimum distributions (“RMDs”) from my traditional IRA. Am I eligible to convert a portion or all of my traditional IRA?

A20: Yes. The one thing to be aware of here is that the RMD for the year of conversion – if not yet taken – cannot be converted. Thus, many people take their RMD for the year and then convert.

Q21: A significant amount of my assets consist of qualified plans and tax-deductible IRA’s. If I convert any of these accounts to a Roth IRA, can I pay the taxes from those accounts as well?

A21: Yes, but it is generally not advisable. First, the withdrawal itself will be taxable. If you are under 59½, you’ll now owe penalties, as well. Also, the withdrawal will lose its ability to compound tax-deferred inside the plan or IRA. Conversion to a Roth IRA works best when the money needed to cover the taxes comes from sources other than the retirement plans or IRA accounts that were converted.

There is a significant opportunity for effective income tax and retirement planning by converting traditional IRAs and qualified plans to Roth IRAs. However, there are many rules and restrictions that must be understood and complied with. This memo is intended to educate you on some of these rules and restrictions. You should consult with your personal advisors and tax professionals before taking any action with regard to conversions or re-characterizations.

Contact Connie Dello Buono 408-854-1883 motherhealth@gmail.com for a free 30 min chat with a financial advisor.

Hi,

I’m Connie, financial advisor with Harding Financial helping doctors and business owners save $70k or more in income taxes per year via a financial strategy and business structure.  I can schedule a phone chat with you and our sr financial advisor this week.  Please email me at conniedbuono@gmail.com or connie.dellobuono@hardingfp.com

Regards,

Connie Dello Buono

Harding Financial

hardingfp.com

Financial Advisor

408-854-1883