Post-2009 Roth IRA Rollovers

Dear Client:

You may roll over amounts in qualified employer-sponsored retirement plan accounts, such as 401(k)s and profit sharing plans, and regular IRAs, into Roth IRAs—regardless of your adjusted gross income (AGI).

What's so attractive about a Roth IRA? Here's a summary:

  • Earnings within the account are tax-sheltered (as they are with a regular qualified employer plan or IRA).
  • Unlike a regular qualified employer plan or IRA, withdrawals from a Roth IRA aren't taxed if some relatively liberal conditions are satisfied.
  • A Roth IRA owner does not have to commence lifetime required minimum distributions (RMDs) after he or she reaches age 70 1/2 , as is generally the case with regular qualified employer plans or IRAs.
  • Beneficiaries of Roth IRAs also enjoy tax-sheltered earnings (as with a regular qualified employer plan or IRA) and tax-free withdrawals (unlike with a regular qualified employer plan or IRA). They do, however, have to commence regular withdrawals from a Roth IRA after the account owner dies.

The catch, and it's a big one, is that the rollover will be fully taxed, assuming the rollover is being made with pre-tax dollars (money that was deductible when contributed to an IRA, or money that wasn't taxed to an employee when contributed to the qualified employer-sponsored retirement plan) and the earnings on those pre-tax dollars. For example, if you are in the 28% federal tax bracket and roll over $100,000 from a regular IRA funded entirely with deductible dollars to a Roth IRA, you'll owe $28,000 of tax. So you'll be paying tax now for the right to future tax-free withdrawals, and freedom from the RMD rules.

Should you consider making the rollover to a Roth IRA? The answer may be “yes” if:

  • You can pay the tax on the rollover with non-retirement-plan funds. Keep in mind that if you use retirement plan funds to pay the tax on the rollover, you'll have less money building up tax-free within the account.
  • You anticipate paying taxes at a higher tax rate in the future than you are paying now. Many observers believe that tax rates for upper middle income and high income individuals will trend higher in future years.
  • You have a number of years to go before you might have to tap into the Roth IRA. This will give you a chance to recoup (via tax-deferred earnings and tax-deferred payouts) the tax hit you absorb on the rollover.
  • You are willing to pay a tax price now for the opportunity to pass on a source of tax-free income to your beneficiaries.

Individuals ineligible to make deductible contributions to a traditional IRA, or to make any regular contributions to a Roth IRA, due to limitations based on adjusted gross income, may contribute to a traditional IRA and then convert this amount to a Roth IRA. So individuals who have never opened a traditional IRA because they weren't able to make deductible contributions (and who have never rolled over pre-tax dollars to a regular IRA) should consider opening such an IRA and making the biggest allowable nondeductible contribution they can afford. If they convert the traditional IRA to a Roth IRA they will have to include in gross income only that part of the amount converted that is attributable to income earned after the IRA was opened, presumably a small amount. They could continue to make nondeductible contributions to a traditional IRA in later years, and roll the contributed amount over into a Roth IRA. However, note that if an individual previously made deductible IRA contributions, or rolled over qualified plan funds to an IRA, complex rules determine the taxable amount.

We should discuss your and your family's entire financial situation before you plan for a large rollover to a Roth IRA. There also are many details that we should go over, such as whether the amounts you are thinking of switching to a Roth IRA are eligible for the rollover (technically, they are called “eligible rollover distributions”), whether you can make rollovers from your employer sponsored plan (for example, there are restrictions on rollovers from 401(k) plans), and the tax impact of rolling over amounts that represent nondeductible as well as deductible contributions.

Very truly yours,

Cohen & Grieb, P.A.

© 2010 Thomson Reuters/RIA. All rights reserved. 

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