Roth IRAs for estate planning get a big boost from Congress

Many people should consider converting a regular IRA or old 401(k) plan into a Roth IRA, as a result of a change that takes effect on January 1 of next year. 

With a regular IRA, contributions are often tax-deductable, but you have to take a certain amount of money out of the account each year once you turn age 701/2, and you have to pay income tax on the withdrawals.  If you leave the IRA to your heirs, they will have to pay income tax on the money they take out.

With a Roth IRA, there’s no tax deduction for contributions, but withdrawals are tax-free.  Roth IRAs can be better for estate planning because:

1)      There are no required distributions.  So if you don’t need the IRA funds to live on, you can leave the entire IRA to your heirs without having it diminished each year. You’ll leave more to your  heirs because you wont have to pay tax on the annual distributions.

2)      Your heirs wont have to pay income tax on their withdrawals.

3)      If tax rates go up (which seems likely), you’ll save because you’ll contribute after-tax dollars at today’s rate, and wont have to pay taxes on withdrawals at a higher rate in the future.

In the past, many people were not allowed to convert a regular IRA into a Roth IRA.  Conversions were prohibited for taxpayers with modified adjusted gross income of $100,000 or more and for married taxpayers filing separately regardless of what their income was. 

However, starting January 1, 2010, these restrictions will be eliminated and anyone can convert a regular IRA or an old 401(k) plan into a Roth IRA.  The one drawback is that if you convert to a Roth, the amount you convert is considered taxable income to you, and you have to pay income tax on it.  And you’ll need to be able to pay the taxes from a source other than the IRA itself, since taking money from the IRA would defeat the purpose of the conversion. 

However there are a number of reasons why this might be a good time to make a conversion:

1)      The value of many people’s IRAs is at a low point right now, as a result of the last year’s stock market losses.  So it might make sense to convert now rather than wait until the value of the IRA goes up and more taxes are owed.

2)      Converting now lets you pay income taxes at current rates, rather than paying at future rates which might well increase significantly.

3)      There’s a one time incentive for conversions in 2010, thanks to Congress.  If you convert in 2010, you can report no income from the conversion on your 2010 tax return, then report half the amount as 2011 income and the other half as 2012 income.  In this way you can delay paying the tax. 

4)      You might not owe tax on the whole amount.  This is true if you’ve made any nondeductible IRA contributions over the years.  If you can figure out what percentage of your contributions to all your IRAs were nondeductible including any IRAs resulting from 401(k) rollovers, then you don’t have to pay tax on that percentage of your Roth conversion.

5)      You don’t have to convert your entire IRA to a Roth all at once.  You can convert only as much as you’re comfortable with, and you can convert additional amounts in future years.  For instance, you might want to convert only the maximum amount in 2010 that will keep you in the same tax bracket.

6)      If you change your mind, you can undo a Roth conversion with no tax penalty up until October 15 of the conversion year.

With a Roth IRA, you’ll leave more to your heirs because you won’t have to pay tax on annual distributions, and your heirs won’t have to pay tax on their withdrawals.  After you convert to a Roth IRA, you can contribute additional money to the account each year – unless you have modified adjusted gross income above $120,000 for single filers or $176,000 for married couples.  However, even if your income is above that level, you can still contribute.  Just put the money into a regular IRA, then convert that IRA to Roth.

By the way, the fact that you can undo a Roth conversion up until October 15 with no penalty creates the opportunity for some sophisticated investment planning.  Suppose you plan to invest in three asset classes.  You can convert the regular IRA funds into a three separate Roth IRAs each of which is invested in a different asset class.  Supposed that by October, two of the Roth IRAs have increased in value, and one has lost money.  You can undo the conversion for just the loser, and in that way you won’t have to pay taxes based on the higher value of the loser at the time of the conversion.