December 1, 2010

From IRA to Roth—A Tempting Road to Tax-Free Income

By John B. Huffaker and Richard M. Schwartz

An Individual Retirement Account (IRA), as defined in section 408 of the Inter- nal Revenue Code (IRC), has been the tax-favored vehicle used by most members of the Senior Lawyers Division to provide for their retirement. A newer vehicle, a Roth IRA (Roth), defined in section 408A of the IRC, is an alternative way to fund retirement.

As of January 1, 2010, all members of the Senior Lawyers Division who have an IRA can elect to convert all or any portion of their IRA into a Roth. 

Up until that date, Roths were unavailable to most members due to the income ceiling. While contributions to a Roth are limited by the rules that limit contributions to qualified plans, conversions from IRAs to Roths are not limited. Almost every member of our Division will have an opportunity to convert: Those who are covered by qualified plans rather than IRAs may be able to transfer from their qualified plan to an IRA and from their IRA to a Roth. Thus, all of us should learn about Roths as a matter of self-interest. Here are the major considerations for most of us.

The Attractiveness of Roths

The shorthand description of a Roth is that contributions are not deductible, but both the income earned by the Roth and the distribution to its beneficiary over 59½ are tax free. If the Roth is funded with a conversion from an IRA, all the earnings of the Roth will be tax free when received by the Roth and when distributed to the beneficiary. So, the earlier you convert, the longer the fund can grow tax free. Most of us plan for our family to also enjoy our IRA, and the distributions to them from a Roth will be tax free.

The Price of Conversion

The distributions from a Roth to an owner over 59½ are income tax free, but the distribution by the IRA to the Roth generates ordinary income subject to tax. For conversions in 2010, the tax may be paid as part of your 2010 income tax or half treated as 2011 income and half as 2012 income. Think not only of the income anticipated in 2011 and 2012 but also what rates are likely to be. If the IRA received some contributions that were not deductible, a portion of the conversion from the IRA to the Roth may be tax free.

The Decision to Convert

Just about every senior who is not an incurable pessimist about the economy or who intends his entire IRA to go to charity should elect to convert. The opportunity cost is low, so even pessimists should elect because they have a year to change their elections. However, if he anticipates a falling stock market, he may not want to make the election early in the year. For most of us, the earlier the conversion, the sooner to start earning tax-free income and the greater the appreciation that will be free from tax.

The decision is made easier by a one-year period during which the election can be reversed. The teaching of history is that some stocks go up and some go down. Most advisors suggest you have a separate Roth for each class of stock. For example, one Roth for energy stocks, another for utilities, and so forth. There is apparently no limit on how many Roths you may have.

Impact on Estate Tax

Seniors have a major concern when

(1)  their potential estate is likely to be subject to federal estate tax, and

(2)  their IRA is a significant asset. If an IRA beneficiary must take distributions from the IRA to pay the estate tax, the total tax will swallow most of the IRA. The conversion to a Roth helps on both scores. The income tax on the conversion reduces the potential estate tax, and any distribution from the Roth to help with the tax burden will be tax free.

Charities as Beneficiaries

Many of us have planned to use our IRAs as a source for charitable bequests. Because charities are tax exempt, your IRA should be continued as a potential source for charitable distributions at your death. When charities are not the sole beneficiary of the IRA at your death, there are advantages in a dollar gift to charity that can be paid within a year.

Deciding  How  Much  to  Convert

The conversion can be any amount that was in your IRA, and you can have multiple conversions in the year. Most advisors would limit the conversion to amounts that generate a tax that can be paid from sources other than distributions from the IRA. The election to defer the inclusion in income until 2011 and 2012 gives you time to gather the toll charge. However, the tax on post-2010 conversions will be imposed currently.

Escape From Required Minimum Distributions (RMDs)

The requirement to have a minimum distribution in 2010 is based on December 31, 2009, values. It will be computed without regard to the election. But once the assets are in the Roth, they are not subject to an RMD. This will permit you to keep the fund growing instead of the erosion of increasing RMDs. A beneficiary will have the benefit of tax-free distributions but must withdraw the fund over his life expectancy.

Limitations on Withdrawal

There is a special five-year rule applicable to withdrawal of amounts that have not been in a Roth for five years. However, in the case of conversions by seniors, it appears that the limitation will not apply. The example on page sixty-nine and the table on page seventy of IRS Pub. 590 make this clear.

Fine-Tuning the Election

There are several programs on the market that make the computation easier. However, the key is your feeling about the stock market, income tax rates, and what you can afford. Do not overlook the financial status of your beneficiaries.

Later Additions

The right to make a conversion from an IRA to a Roth is a part of the IRC. Based on precedent, even if future conversions are not permitted, funds that move to a Roth before the law is changed will keep their favored status.

Considering State Law

If you are considering a change in residence, you must be mindful that your present state of residence and your anticipated state of residence may treat a conversion differently. You may find your current residence is more favorable, and you should hasten to convert before you move. Or, conversely, you should delay until after your move.


Many of us fear that income tax rates will go sky high to pay for the spending designed to avoid a depression, reform health care, and so forth, and that inflation is inevitable. Maybe funds from a Roth are a key to a less worrisome dotage and a grateful family. At least it is worth thinking about.

This article was written for seniors and avoids important issues for younger IRA owners. The brevity of the article and the complexity of the subject mean that you should take the information provided here as an introduction to the question, and it is knowingly incomplete. If you do find any errors, we would appreciate being told

John B. Huffaker and Richard M. Schwartz are members of the Pennsylvania Bar and the ABA Section of Taxation. The former is a member of the Senior Law- yers Division and a retired part- ner from Pepper Hamilton LLP. The latter is an associate in the Estates Group of that firm in its Philadelphia office.