Convert to a Roth?
A new tax law allows more seniors to switch from traditional to Roth IRAs and offers additional flexibility to taxpayers taking required minimum distributions (RMDs). By Phil Dyer, CFP

Since its creation in 1997, the Roth IRA has been a popular financial planning and estate-planning tool. Funded with after-tax dollars, distributions from Roth IRAs are income-tax-free, as long as they meet several qualifications:

• Roth IRA contributions may be withdrawn at any time, without tax or penalty, as long as earnings are not touched.
   
• After a five-year holding period from the initial contribution, Roth IRA earnings may be withdrawn tax-free if the taxpayer is 591¼2, if the distribution is caused by the account holder’s death or disability, or if the distribution is made to a qualified first-time home buyer ($10,000 lifetime limit).
   
• Unlike traditional IRAs, Roth IRAs are not subject to RMD rules at age 701¼2, allowing tax-free compounding to be passed on to heirs.

Thanks to a 2005 tax law change, more seniors now will be eligible to convert traditional IRAs to Roth IRAs. To do this, a taxpayer’s modified adjusted gross income (MAGI) must be under $100,000. The amount converted from a traditional to a Roth IRA has never counted against the $100,000 limit, but the RMD did count toward calculating the MAGI through the 2004 tax year.

Beginning in 2005, taxpayers subject to the RMD on their IRAs can exclude the RMD amount from their MAGI calculation for Roth conversion purposes. This change is welcome news to those prevented from pursuing a full or partial Roth IRA conversion because the RMD puts them over the income limits. For example: Joe is a 76-year-old retired O-5, and his wife, Sue, is 72. They file jointly, and their total income — military pension, private pensions, and taxable Social Security — is $85,000. His traditional IRAs totaled $750,000 on Dec. 31, 2004. According to the new IRS Uniform Life Table, his life expectancy is 22 years, which yields an RMD of $34,091 ($750,000 divided by 22).

Before the new rule, the addition of the RMD to other income would put Joe and Sue over the $100,000 MAGI limit ($119,091). Now, the RMD is excluded for Roth IRA conversion purposes — allowing Joe and Sue to convert some (or all) of Joe’s remaining traditional IRA to a Roth IRA. They will pay taxes on the converted amount, and the RMD amount itself cannot be included in the conversion, so Joe would be eligible to convert up to $715,909 ($750,000 minus $34,091) of remaining traditional IRA assets. Joe and Sue still will need to identify funds to pay the taxes due on the conversion, but they would be eligible immediately for tax-free withdrawals in future years because they are over age 59 1/2.