© by Theodore "Ted" Kleinman, CPA

One of the more interesting choices created by the 1997 Tax Act is the option of transferring existing IRA balances [including money that originally came from a 401(k) or profit-sharing plan] into a new form of IRA called a Roth IRA. The transfer causes the IRA funds to be taxed as if they were withdrawn rather than rolled into a new IRA. However, once the funds have been in the Roth IRA for at least five tax years, they (and any earnings) can be withdrawn tax free if the money is used for first-time home-buyer expenses (up to $10,000) or the withdrawal occurs after you reach age 59½, die, or become disabled.

Another major benefit of a Roth IRA is that unlike a regular IRA, there's no requirement to begin taking minimum distributions from a Roth IRA at age 70½. Thus, if you don't need the money, funds inside a Roth IRA can potentially continue compounding tax-free for many years longer than they could in a regular IRA.

Not Everyone Will Qualify

To be eligible to convert (or roll over) your current IRAs to a Roth IRA, your modified adjusted gross income for the year of the conversion can be no more than $100,000, and married individuals have to file a joint return. (Modified adjusted gross income for most taxpayers is the number at the bottom of page one of their Form 1040; however, for this purpose it does not include the income triggered by the conversion.) The same $100,000 limit applies to single and married taxpayers.

So are you out of luck if you'd like to roll funds into a Roth IRA but your income is above $100,000? Not necessarily. The opportunity to convert is based solely on fitting below the $100,000 limit in the year of conversion. Thus, even if you regularly have more than $100,000 of income, you may still qualify by shifting income out of (or pulling deductions into) the applicable year. For example, suppose you're trying to squeeze within the $100,000 limit in 2000 but it looks like your modified adjusted gross income (modified AGI) might come in at a little more than that. If you're self-employed and use the cash method of accounting, you may be able to delay sending bills in late 2000 so the revenue isn't collected until 2001. Or perhaps you can reduce your 2000 income by fully funding a retirement plan such as a simplified employee pension (SEP) or SIMPLE IRA.

If you work for your own C corporation, you might consider taking a reduced salary in 2000 and then paying yourself a bonus in January 2001 (as long as the salary adjustments stay within the bounds of what the tax laws consider “reasonable compensation”). If you're employed by someone else, you may be able to reduce your 2000 income by contributing more of your salary to your 401(k) or 403(b) retirement plan, or by taking full advantage of a flexible spending or dependent-care account sponsored by your employer. And finally, if you're already retired, you may be able to reduce income by shifting any planned 2000 IRA distributions to 2001 (although if you're over age 70½ you will probably still want to take your required minimum distribution in 2000 to avoid a penalty).

For investors it may be possible to push some investment income out of 2000 by buying one-year Treasury bills that don't mature until 2001 or by converting taxable investments into tax-free municipal bonds. Because capital losses offset capital gains and up to $3,000 of ordinary income, 2000 also may be a good year to dump some investments that have dropped in value.

To Convert or Not To Convert

Assuming your 2000 income will be no more than $100,000 (or that you can find a way to get it there by moving income and deductions around), the real issue becomes whether it makes sense to convert part or all of your IRAs to Roth IRAs. Unfortunately there isn't a simple answer. The correct conclusion depends on such factors as how long you will likely leave the funds in the Roth IRA, what your tax rate is now and what you estimate it will be when withdrawals are taken, and whether you have to use funds from the IRA to pay the tax due at conversion. Generally, you will see a significant benefit from transferring funds to a Roth IRA when:

1. You (or your beneficiaries) won't need to take withdrawals from the IRA for at least 10 to 20 years;

2. Your (or your beneficiaries') tax rate when withdrawals are taken in the future is no less than it is at the time of the conversion (thus, if Congress abolishes our current income tax system or dramatically lowers the rates and replaces or supplements the current tax system with a value-added tax or national sales tax, paying tax now to roll funds into a Roth IRA could be a major mistake); and

3. You can afford to pay the tax due on the conversion with funds from outside the IRA.

In fact, if you do not have outside funds to pay the tax at conversion, that alone can make a conversion to a Roth IRA unfavorable. Funds withdrawn from either a regular IRA or Roth IRA to pay the conversion tax will normally be subject to the 10% early withdrawal penalty if you are under age 59½. In addition, if the withdrawal is from a regular IRA, income tax will apply to the amount withdrawn to the extent it isn't attributable to nondeductible contributions.

Other Income Tax Issues to Consider

In addition to the direct impact a conversion has on your taxable income in the year of the conversion there may also be an indirect effect. For example, several of the tax benefits added by the '97 Tax Act are not available if your income is over a certain level. Thus, in the year(s) in which your income increases because of a Roth IRA conversion, you could miss out on such benefits as the child or education credits or the deduction for interest expense on a loan for higher education expenses. Other items that could be adversely impacted by a jump in income include the $25,000 rental exception to the passive loss rules, the personal exemption and general itemized deduction phase outs, the medical and miscellaneous deductions, and the $2,000 regular IRA deduction for individuals covered by a pension plan.

Estate Taxes May Also Affect Your Decision

Even with just the income tax issues we've discussed thus far, the decision on whether you should transfer regular IRA funds to a Roth IRA is complex. However, if you have significant assets, you should also consider the impact of estate taxes.

A traditional IRA is potentially subject to income and estate tax at the accountholder's death. To help offset this “double” taxation, the beneficiary of the account is allowed a deduction to the extent estate taxes were paid because of the IRA. However, the deduction is not available for any additional state death taxes paid, and it phases out once a beneficiary's income reaches a certain level. Thus, in many situations (including some where no estate tax is owed), the income tax effect of inheriting a regular IRA can be quite onerous.

Although a Roth IRA can also be subject to estate tax (depending on the size of the accountholder's estate), it's not subject to income tax after the accountholder's death if the five-tax-year holding rule has been satisfied. In addition, when a regular IRA is converted to a Roth IRA, the accountholder's taxable estate is reduced by the income taxes paid as a result of the conversion. (With a regular IRA, the income taxes that will ultimately be owed when distributions are withdrawn from the IRA are not allowed as an estate tax deduction.) Thus, a Roth IRA conversion will generally be an attractive estate-planning tool.

Conclusion:

A Roth IRA's two biggest advantages are the ability to take tax-free withdrawals (if the conditions we discussed previously are satisfied) and the fact that there's no mandatory distribution rule at age 70½. Because of these benefits, a Roth IRA can potentially be used to accumulate a much larger amount of funds for your own retirement or future generations than if the money is left in a regular IRA. Even if you'll need to take withdrawals in the foreseeable future, the lack of a mandatory distribution rule allows you the flexibility to time your withdrawals to suit your needs (thus allowing the most money possible to remain in the Roth IRA and accumulate tax free).

However, despite these advantages, the decision about whether it makes sense for you to roll over part or all of your existing IRA funds to a Roth IRA depends on your own unique tax and financial situation. If you would like help in making this decision (one of the most important financial ones you may ever make), please do not hesitate to call me. Please share this information with family and friends.

Theodore "Ted" Kleinman, CPA is a Certified Public Accountant with 20 years diversified business experience, who specializes in international taxation preparation and planning. His public accounting experience includes auditing, tax planning and preparation, and management advisory services in diversified industries from real estate development and construction to manufacturing, service, and professional corporations.

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