A Roth individual retirement account, unlike a traditional IRA, allows for tax free growth of the capital base and tax free distributions (after the account has been in existence at least five years). Effective January 1, 2010, The Tax Increase Prevention and Reconciliation Act of 2005 will eliminate the existing income threshold governing conversions of existing individual retirement accounts to Roth accounts.  Under the current law, many taxpayers are not eligible to execute a ROTH IRA conversion because their modified adjusted gross income exceeds $100,000.  Starting on January 1, 2010 the $100,000 limitation will no longer apply.   Taxpayers may choose to convert all or a portion of their individual retirement accounts to a Roth account.  The conversion requires the taxpayer to recognize the value of the converted individual retirement account as ordinary income and pay current income tax on that income.  The income tax burden can be spread over two years.

When considering a Roth conversion, a taxpayer must be cognizant of current income tax rates, estate tax rates and his current estate tax exposure, life expectancy, and cash flow needs.  Future income tax rates and estate tax rates should also be considered.  The benefits to a conversion not only include the tax free growth of the capital base along with tax free distributions inherent to all Roth accounts, but also that required minimum distribution rules do not apply.  This latter benefit may appeal to individuals looking to accumulate funds for their heirs.  After the taxes have been paid on the amount converted, taxpayers may experience lower income taxes in future years due to the elimination of a taxable required minimum distribution.  This may result in a reduction in the amount of social security being taxed and also reduces the income base for purposes of medicare premiums, possibly resulting not only in lower income taxes but also reduced medicare premiums.

Taxpayers who can pay the tax due upon conversion with funds outside of their IRA accounts stand to benefit the greatest from a conversion.  By utilizing outside funds to satisfy the tax due upon conversion, a greater amount of the capital base is maintained in the newly formed Roth IRA account. Because Roth IRA accounts allow for tax free growth and are not subject to the required minimum distribution rules, a greater amount of wealth could be generated and ultimately preserved for the taxpayer’s heirs.  Conversely, if a taxpayer does not have adequate funds available outside of his IRA account, and plans to use IRA funds to pay the tax due upon conversion, a ROTH IRA conversion becomes a less attractive option.  Taxpayers in this situation may still benefit from a conversion or a partial conversion to a Roth account, but further considerations will need to be given to the taxpayer’s life expectancy, current and future marginal tax rate and cash flow needs.
A Roth conversion is not a “one size fits all” solution for taxpayers.  Each individual’s circumstances are unique and can greatly impact the effectiveness of a Roth conversion.  A financial analysis should be performed that considers all of the factors above before a Roth conversion is pursued.  Further, various estate planning techniques should also be considered with any proposed Roth conversion to maximize its benefits, and should become an important component of this analysis.

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