Roth IRA conversions as an asset protection strategy: does it always work?

• Author: Pratt, David
• Position: Tax Law

Prior to 2010, a traditional individual retirement account could be converted to a Roth IRA only when the account holder's modified adjusted gross income was $100,000 or less. Beginning in 2010, all taxpayers, regardless of their income levels, are eligible to take advantage of the opportunity to convert their IRAs to one or more Roth IRAs. (1) Typically, taxpayers consider Roth IRAs solely as a means of generating long-term income tax savings; however, a Roth conversion may have consequences (sometimes good and sometimes bad) from an asset protection perspective.

Comparing Traditional IRAs and Roth IRAs

With a traditional IRA, a taxpayer typically makes contributions with "pre-tax" dollars, and the investment is allowed to grow on a tax-deferred basis; that is, amounts earned, including the appreciation and income earned within the IRA, are not taxed until distributions are made to the IRA owner or beneficiary. (2) Additionally, traditional IRAs are subject to mandatory distribution requirements when the taxpayer attains age 70 1/2. (3) Such mandatory distributions are generally referred to as "required minimum distributions," or RMDs. These forced distributions result in income tax to the taxpayer each year after attaining age 70 1/2, while continuously diminishing the tax-deferred amount remaining in the account (subject to offsetting growth and income in the account).

Conversely, contributions to Roth IRAs and "converted" Roth IRAs are considered made with "after-tax" dollars and, consequently, the appreciation and income inside a Roth IRA grows tax-free. Therefore, there is no income tax when the taxpayer withdraws money from the Roth account in retirement or when distributions are made to his or her beneficiaries.

Furthermore, Roth IRAs are not subject to RMDs when the taxpayer attains age 70 1/2. Consequently, distributions from a Roth IRA to the account owner do not have to be made. More importantly, from an asset protection perspective, because Roth IRAs do not have RMDs with respect to the account owner, creditors of the owner generally cannot assert a claim against amounts in a Roth IRA unless the taxpayer makes a voluntary withdrawal from the account. Thus, it may make sense for an individual with potential creditors who is approaching or has attained the age of 70 1/2 to convert his or her IRA to protect any RMDs.

Asset Protection

* Exemptions Under State Law--In Florida, whether a retirement account (traditional IRA or Roth IRA) is exempt from creditors depends on Florida law. F.S. [section]222.20 provides that pursuant to [section]522(b) of the Bankruptcy Code of 1978, (4) "residents of this state shall not be entitled to the federal exemptions provided in s. 522(d) of the Bankruptcy Code." (5) Consequently, the relevant exemption provision is F.S. [section]222.21(2)(a), which generally provides that both traditional IRAs and Roth IRAs are exempt from the creditor claims of an owner of such an IRA. (6) However, amounts distributed as RMDs from a traditional IRA are not necessarily considered to be exempt property under F.S. [section]222.21(2)(a) and, thus, may not be protected from claims of the distributee's creditors. Query whether a fraudulent conversion or transfer occurs by converting into exempt property (i.e., the Roth IRA) property which would otherwise be distributed as nonexempt property (i.e., the RMDs). Consequently, Florida's fraudulent conversion and transfer laws must be considered. (7)

* Fraudulent Conversion and Transfer Laws--Under Florida law, a conversion by a debtor of a nonexempt asset to an exempt asset is a fraudulent conversion as to a creditor, which may be set aside by such creditor "whether the creditor's claim to the asset arose before or after the conversion of the asset, if the debtor made the conversion with the intent to hinder, delay, or defraud the creditor." (8) The relevant queries are as follows: 1) Does the conversion to a Roth IRA constitute a "conversion" to which Florida's fraudulent conversion law applies, and 2) with regard to creditors' claims arising before and after the Roth IRA conversion, did the debtor engage in the conversion with the actual intent to hinder, delay, or defraud such creditors? As...