CONSIDER A CONVERSION TO A ROTH IRA
By Donald J. Winkler
Lawrence E. Swartwood
As we all know, every financial institution in town has been talking about converting regular, garden variety IRAs into hot-off-the-press tax-free Roth IRAs. Many taxpayers are curious as to why their professional tax advisors have not encouraged them to make the conversion. As you may suspect, the decision to convert is not an easy one to make and may not even be an option for certain taxpayers.
The first hurdle to overcome is determining whether the taxpayer's modified adjusted gross income exceeds the threshold ceiling of $100,000 in the year of conversion. If it does, the decision is simple; you cannot convert to a Roth IRA. Note, that in determining your modified adjusted gross income, municipal income is still included, but minimum distributions from regular IRAs are not included.
Assuming you qualify and you decide to convert to a Roth IRA, the transaction is treated as a liquidation of your regular IRA. Normally, the tax on the IRA liquidation is due in the year you liquidated. However, for 1998 conversions only, you will spread the resulting income over four years and pay the tax in installments. Depending on your own situation, this may not be a good thing. For most of us planning on converting our regular IRA to a Roth IRA, 1998 may be the best year to convert because of the spreading of income and related tax liability over time.
Another consideration you need to make if you convert is; you will need to consider how to pay the taxes on the liquidation of your regular IRA. In an ideal world, you would pay the taxes out of non-IRA funds. This accomplishes two goals; one, the amounts built up in your regular IRA tax deferred continue to grow tax deferred and, two, if you are under 59-1/2 years of age, amounts from your regular IRA that are not rolled over attract penalties (10% Federal, 3.333% California). Payment of the taxes, whether over four years or one year if the conversion is done subsequent to 1998, may involve some difficult investment decisions.
If your regular IRA is funded primarily with stocks and equity mutual funds, stock market conditions should be considered before you make the Roth conversion. Ideally, the conversion has maximum tax advantage when made at the low value point of your regular IRA portfolio during 1998. This will result in the minimum regular IRA balance which will be subject to tax. If you make a conversion and the market goes down, you will incur an inflated tax bill based on value that is no longer available to you. Consider taking the following actions:
- You may want to defer the decision to make a conversion until year end. If the market goes down, your tax bill will be reduced by waiting until the end of the year. If the market goes up, the choice is whether to convert this year (to take advantage of the four-year spread) or convert in 1999 to defer the tax liability (without a spread); or
- You may want to play the 60 day rollover game, which means that the conversion should be deferred until year-end. In effect, you have 60 days to roll over the securities into a Roth account or back into a regular IRA. If the market goes down during the 60-day window, you can roll back into a regular IRA with no harm done. If the market goes up, you can go the Roth route. This will be considered a 1998 conversion. Your tax bill will be based on the lower value when you liquidated the regular account at year-end. Finally, you will still qualify for the four-year spread. You need to be careful of withholding requirements and roll over the appropriate amounts.
What if you actually converted earlier this year, and now your Roth account is loaded with equities? In that case, the recent market declines may have significantly reduced the value of your Roth account. You should give this another hard look to see if you are happy with this situation. If not, consider unwinding the conversion by making a "trustee-to-trustee" transfer of your Roth account assets (plus any earnings) back into a regular IRA now. You can then evaluate "reconverting" before the end of this year at a hopefully much lower tax cost. You'll still be able to take advantage of the four year-spread. Or you could wait until 1999 to reconvert. However, that would mean including 100% of the resulting income in next year's return (no four-year spread).
On the other hand, you may be quite enthusiastic about converting but know you can't because your income will be a tad over the $100,000 limit. However, if you hold some investment losers (market value less than cost) in taxable accounts, consider selling enough to get your income below $100,000. (The losses are deductible as long as they don't exceed your capital gains plus an additional $3,000.) This restores the Roth conversion option to your tax planning arsenal.
Donald J. Winkler, CPA, JD, is a Senior Tax Manager and Lawrence E. Swartwood, CPA, is a Principal in the Tax Department with Alder, Green & Hasson LLP, a full service accounting and business consulting firm. Don specializes in tax and estate planning. Larry specializes in international taxation issues.
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