Michigan Tax Law

Conventional Individual Retirement Accounts have been with us since 1974. IRAs can be funded up to certain limits annually. The limits currently are $5,000 per year for people under age 50, and $6,000 per year for people over that age (up to the amount of the taxpayer’s earned income). If the taxpayer either doesn’t have another retirement plan, or his income is under certain limits, the contributions to the IRA can be deducted from taxable income. (The limits are $65,000 for a single person covered by a retirement plan, $109,000 for a married couple both covered by retirement plans, and $176,000 for married person whose spouse is covered by a retirement plan.) If the taxpayer is not eligible to make a deductible contribution, he may still make a non-deductible contribution—if he wants to keep track of the “basis” of the IRA on which tax has been paid for the rest of his life.

Roth IRAs have been around since 1997. Roth IRAs can be funded up to the same annual limits as conventional IRAs. Roth IRA contributions are not deductible from income, but qualifying withdrawals from Roth IRAs are totally tax free.

Taxpayers have been allowed to “convert” conventional IRAs into Roth IRAs since Roths have existed, by paying income tax on the amount converted. For many years only taxpayers with Adjusted Gross Income of less than $100,000 (excluding the conversion) were allowed to convert their IRAs into Roths.

Beginning in 2010 there is no longer an income limit on converting a conventional IRA (or some other defined contribution retirement accounts) into a Roth IRA. Many more people will qualify, and many will find it advantageous.

The reasons to convert to a Roth IRA are:

1. Convert to avoid future tax rate increases.
2. Convert to use your tax-sheltering attributes.
3. Convert to make your taxable savings tax-free.
4. Convert to maximize funds passed to your heirs.

1. CONVERT TO AVOID FUTURE TAX RATE INCREASES

Do you expect that tax rates will increase over the rest of your life? We seem to be asking government to do more and more for us, which eventually will increase our tax bills.

If you expect tax rates to go up, you can “lock in” present tax rates on your IRA by converting to a Roth. If you convert this year, you can pay this year’s rates. Future income on your retirement account, and future withdrawals are tax free.

Locking in the present tax rates may turn out to be a wise move if rates increase, even for people who plan to use their Roth IRA to fund their retirement. Roth distributions are not listed on your tax return, so disadvantages that are based on Adjusted Gross Income are reduced: less of your Social Security benefits are taxed, or less are taxed at the higher rates. Property tax credits to low income taxpayers  are increased. Reductions of itemized deductions or exemptions might be avoided. Alternative Minimum Tax rules might be avoided by having less  taxable income.

2. CONVERT TO USE YOUR TAX-SHELTERING ATTRIBUTES

Do you have tax attributes that make your tax rate this year exceptionally low? A Net Operating Loss or a Disaster Loss? Early retirement with little taxable income? Charitable contribution carryovers? Exceptionally large itemized deductions?

If you have any tax attributes that wipe out your income, consider taking advantage of them by filling the tax-free hole with otherwise taxable retirement funds. Be more aggressive, and withdraw enough to use the entire 10% and 15% tax brackets. It’s unlikely you will regret it. You may be able to make a series of withdrawals to convert your retirement into a Roth at little or no cost—and have the Roth advantages described below.

3. CONVERT TO MAKE YOUR TAXABLE SAVINGS TAX-FREE

Roth conversions work best when the tax on the conversion can be paid with funds that would otherwise produce taxable income. The funds are paid to IRS, and no longer produce taxable income. Your annual tax bill is reduced. Other taxes, costs, and lost deductions, such as the portion of Social Security subject to tax, or property tax relief based on having low Gross Income, will also be moved in your favor.

Equivalent funds within the Roth which would someday have been paid as taxes from a conventional IRA are growing TAX-FREE. That’s tax-free now, and tax-free in the future. Totally tax-free.

4. CONVERT TO MAXIMIZE FUNDS PASSED TO YOUR HEIRS

Retirement plans receive special tax treatment, including tax deduction on their creation, and tax-free growth, in order to provide funds for seniors to live on in retirement. To encourage the notion of providing funds for retirement the Tax Code provides that participants must take mandatory distributions after age 70-1/2. These Required Minimum Distributions create taxable income for the participant, and tax for the United States Treasury. Once the Required Minimum Distributions start, the participant is not allowed to make further contributions to the IRA. (Otherwise participants might simply trade dollars, taking their Required Minimum Distributions, but making an equivalent contribution to the IRA.) Required Distributions encourage the use of the funds during retirement, rather than using the retirement accounts as a vehicle to transfer wealth to the next generation.

Roth IRAs have no Required Minimum Distributions. Since the funds are not taxable on withdrawal, Congress did not provide for mandatory withdrawals during the participant’s life. Roth IRAs can be left entirely alone for the participant’s whole life, if he has other funds to live on. The original Roth, and all of its growth, can be used to pass wealth to the next generation.

Along with the right to maintain the Roth IRA without mandatory distributions, there is no age at which a person having earned income can no longer contribute to a Roth. People who continue to work after age 70-1/2 can continue to add to their Roths.

If you can avoid distributions from your retirement fund, you can continue its tax-free growth.

The people who inherit the Roth (that is, your heirs) are required to withdraw it over their life expectancies, but the period of tax-free growth can be substantial. What other property can you pass on to your heirs  where their income will be tax-free, part of it for the heir’s whole life expectancy.

FEATURES OF A ROTH IRA

Roth IRAs are designed to be created with after-tax money, and are totally tax-free. They can only be created by two methods: using the normal contribution rules for IRAs, or by converting a retirement account into a Roth IRA. Originally only IRAs could be converted into Roth IRAs. Under the current rules, other retirement accounts as well as IRAs can be converted into Roth IRAs upon paying the tax.

Annual contributions can be withdrawn from the Roth IRA at any time after their contribution tax free (after all, the contributions were made with after tax money). IRA conversions to Roths are also tax free, but are subject to an early withdrawal penalty if they are withdrawn within the first five years. After 5 years there is no early withdrawal penalty, and after five years an the participant’s age 59-1/2, all withdrawals are totally free of tax.

If you are the participant considering conversion to a Roth IRA, you are thinking of the advantages of many years ‘ of tax-free growth. But remember, this is YOUR money for all of your life, and if you need it, you can withdraw it.

When there was an income limit on Roth conversions, it was possible for people to convert their IRA into a Roth IRA, and later find that their Adjusted Gross Income was over $100,000, so the conversion was not allowed. To help these people out, the law provided for a “Recharacterization” of the withdrawal: If you wished, any time before your tax return was due, with extensions(that is, up until October 15 of the year following the year of conversion), you could “recharacterize” the Roth IRA as a traditional IRA, meaning that you had simply made a “rollover” of a conventional IRA, and you owed no tax.

With the new rules in 2010 there is no maximum Adjusted Gross Income limitation on the conversion, so there is no reason for allowing a “recharacterization”. Nevertheless, Congress left the provisions in the Code, so it is still available for use. Presumably people will find it useful if the value of their IRA decreases before the final day of making the “recharacteriaztion” election, converting the previous year’s conversions back into a conventional IRA (no tax due on that simple rollover), and converting the now less valuable IRA to a Roth the next year at a lower tax cost.

In fact, you might convert your conventional IRA into two or three Roth IRAs, each invested in different securities. When the final election day came (which could be over 21 months from the initial conversions) the accounts that lost money could be “recharacterized” back to conventional IRAs, for last year’s tax return, and converted again into a Roth in order to lower the tax cost of their conversion. The accounts that had increased in value would be left as completed conversions.

Conversion of retirement funds into Roth IRAs involves projecting likely results several years into the future. It must be done carefully, and should generally be done with professional help. This article is only meant to suggest some of the situations in which a conversion can be beneficial.

References:

Internal Revenue Code:

Section 408A Roth IRAs

Treasury Regulations:

Section 1.408A-0 Roth IRAs; table of contents

Section 1.408A-1 Roth IRAs in general

Section 408A-2 Establishing Roth IRAs

Section 408A-3 Contributions to Roth IRAs

Section 408A-4 Converting amounts to Roth IRAs

Section 1.408A-5 Recaracterized contributions

Section 1.408A-6 Distributions

Section 1.408A-7 Reporting

Section 1.408A-8 Definitions

Section 1.408A-9 Effective Date

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