To summarize the detailed explanation below, Dutch resident taxpayers should be very cautious about converting from a Traditional IRA to a Roth IRA. Here’s why:
For 2010, the strict limits that have kept individuals from converting their “Traditional” IRA’s to “Roth” IRA’s have been removed. This is being seen as a great benefit that taxpayers should seriously consider taking advantage of. If you haven’t read about it in the news, you haven’t been paying attention (or in any case you aren’t a nerdy tax professional like me!).
Why would you want to convert?
With a Traditional IRA, you typically take a tax deduction when you contribute to the account. However, when you distribute the money (e.g. in retirement) you need to pay tax on the full distribution (unless you have made “non-deductible” contributions, which Dutch residents should consider but I won’t go into here). The idea is that you take the deduction when you are working and in a high tax bracket, then the money grows tax-deferred, then you withdraw from the account when you are retired and in a lower tax bracket. Makes sense for a lot of people.
With a Roth IRA, you do not get a deduction when you contribute to the account. Once the money is in a Roth IRA, you pay no tax on the distributions, including the earnings (if they are qualified distributions, which generally means after age 59 1/2 and the assets have been in the account for at least 5 years). Sound good? It is for most people, especially younger ones. However, due to relatively low income thresholds, it has not been not easy to get money into a Roth IRA.
The BIG news: If you have accumulated amounts in a Traditional IRA, it is possible in 2010 to “convert” these amounts into a Roth IRA, with no limitation on your income. However, the amount converted is seen as taxable income for US tax purposes (federal and most states), so there is a cost now (up to 35% federal tax, plus applicable state tax) for converting. But then you are done. No further US tax will be paid on this account, tax free income forever. Not bad! For more general information on Roth IRA conversions, there is a nice summary on the Consumer Reports website.
BUT – there is a catch for Dutch residents!
If you are a Dutch resident taxpayer, a conversion from a Traditional IRA to a Roth IRA has (at least) two consequences for Dutch tax purposes:
1) The amount converted is considered “Box 1” income, taxable in the same way as wages. This means you will pay Dutch tax of up to 52% on the amount converted, and not the lower US tax rate. Based on the US-NL tax treaty you can use your Dutch tax to offset the US tax on the same income, but you still pay the higher of the Dutch or US tax, which almost always means the Dutch tax.
2) After converting, the amount now in the Roth IRA will be considered a “Box 3” asset for Dutch tax purposes for as long as you remain a Dutch resident. This means you will pay a tax of 1.2% of the average value of the account every year, regardless of income or loss and/or distributions. The 1.2% amount is calculated by assuming a “deemed” return of 4% (regardless of actual return) and applying a flat tax rate of 30%. e.g. 4% X 30% = 1.2%.
Note that taxpayers who have the “30% Ruling” in the Netherlands, and who also have opted for the “partial nonresident” status (which would be most individuals with the 30% ruling), are considered non-residents of the Netherlands for treaty purposes and therefore the income from converting to a Roth IRA is only subject to US tax, so you can generally analyze whether or not to convert using the “normal” analysis for US residents. This does not apply to spouses who do not have the 30% ruling. If this applies to you, you should discuss with your Dutch tax professional before taking action.
Are you reading this too late? Already made the conversion? Luckily, you are allowed to “recharacterize” the conversion at any point up until the 2010 tax return due date, including extensions, so you can correct the issue.