Taking Advantage of the 2010 ROTH IRA CONVERSION Rule

Trade-Offs In A Roth IRA Conversion

Donald Jay Korn    Friday July 31, 2009, 6:25 pm EDT


Deciding whether to convert a traditional IRA to a Roth IRA involves trade-offs. If you convert, you pay tax much sooner than you need to. But conversion can cut your overall tax on your retirement account.

People whose modified adjusted gross income (MAGI) in 2009 will be $100,000 or less face a second decision. If you convert, should you do it now or wait until 2010?  In 2010 a unique but temporary tax break will be available: Roth IRA conversions will be available to taxpayers regardless of Modified Adjusted Gross income, and the taxable income can be divided evenly between 2011 and 2012 returns.

Even if your MAGI is over $100,000 this year, you may need to know the choices so you can advise lower-income children or parents.

First, is a Roth IRA conversion desirable?

You’ll owe income tax on all the untaxed money in the traditional IRA you’re converting. After conversion, all Roth IRA withdrawals can be tax-free. (after five years and after you’re age 591/2).

You’ll never have to take required minimum distributions. RMDs are generally required from a traditional IRA once you hit age 701/2.

In the past, Roth IRA conversions were available only to taxpayers with MAGI of $100,000 or less. That cap will be removed in January. In 2010  anyone with a traditional IRA can convert to a Roth IRA — the first chance for many high-income taxpayers to own a Roth. High income taxpayers generally have been barred from starting Roth IRAs from scratch, too. Eligibility for contributions to a Roth in 2009 phases out for a single taxpayer with MAGI of $105,000 to $120,000. For marrieds filing jointly, phaseout is $166,000- $176,000.

To encourage Roth conversions in 2010 and boost tax collections, Congress created a one-year tax break.

Typically, the income tax from a Roth IRA conversion is due for the year of the conversion. For Roth IRA conversions in 2010 the resulting income can be divided evenly between your 2011 and 2012 tax returns.

Tax Tactic

Say a hypothetical Jim Wilson converts a $300,000 traditional IRA to a Roth IRA in 2010.

So Wilson has $300,000 of taxable income from the conversion. He can report that $300,000 on his 2010 tax return.

Or Wilson can report nothing for 2010. If so, he’ll report $150,000 of that income on his 2011 return. Then he’ll report the other $150,000 on his 2012 tax return.

That brings up the second decision, which faces taxpayers with MAGI of $100,000 or less this year. If you’d like to do a Roth conversion, should you do it now or in January 2010?

The case for doing it now.

Despite the recent rally, many IRA balances are still depressed. The less you have in your IRA, the less tax you’ll owe on a conversion.  After a Roth IRA conversion, any subsequent appreciation can be tax-free. But from today’s low levels, it’s likely that a recovering stock market will drive IRA values higher. So the sooner you convert, the less money that’s likely to be hit by tax.

If you don’t convert until 2010, you may owe more tax on a larger IRA. Market rallies can be fast. The S&P 500 was already up 48% off its March 6 low, going into Friday (7/31/09).

And what if Congress hikes tax rates? If you wait until 2010 to convert, planning to defer the taxable income until 2011 and 2012, you might owe tax at higher rates.

What’s more, converting any time in 2009 starts the five-year clock for tax-free withdrawals back at Jan. 1 of this year.

The case for waiting.

By waiting a few months, you’ll lock in years of tax deferral.

If you convert in January 2010, you can start to enjoy tax-free appreciation right away. Yet you’ll get two and three years of tax deferral because you can delay the final tax payment until 2013, when you file your 2012 return.

Given those choices, how should you proceed? “If a Roth IRA conversion seems attractive now, do it,” said attorney Natalie Choate, with Boston’s Nutter McClennen & Fish.

And if a 2009 Roth IRA conversion turns out to be a faulty move, you can change your mind. A conversion this year can be recharacterized — as the IRS calls a reversal — until Oct. 15, 2010.

Suppose Jim Wilson converts his $300,000 IRA to a Roth in 2009. Let’s say that by October 2010 stocks have soared, and the Roth IRA is worth $400,000. Wilson can leave his Roth IRA in place, with $100,000 of tax-free gains.

But suppose stocks plunge, and Wilson’s IRA falls to $200,000. By Oct. 15, 2010, he can tell his IRA custodian he wants to recharacterize.

After filing an amended return, Wilson will get back any tax he paid on the 2009 conversion. He’ll have a $200,000 traditional IRA.

If he wishes, after waiting 31 days Wilson can convert that $200,000 traditional IRA to a Roth IRA in late 2010. He’ll owe less tax than he owed on the 2009 conversion because of the smaller account size and he’ll be able to defer the tax obligation until 2011 and 2012.


2010 Roth IRA Conversions

Back in May of 2006 there was a pretty significant change to the tax laws involving converting a traditional IRA to a Roth IRA.  In the year 2010 everyone can convert their traditional IRAs to a Roth IRA – and that’s an opportunity that not everyone had in the past.

In this article we’re going to talk about the Roth IRA conversion rule change that goes into effect in 2010.  We’re also run through some of the strategies that individuals can use to take advantage of this change, starting today.

Roth IRA Conversion Rules

Under the current tax law for Roth IRA conversions – which was written in 1997 – individuals were permitted to convert a traditional IRA to a Roth IRA.  There were only two stipulations that taxpayers had to worry about – paying taxes on the converted money and an income limit which determined eligibility to convert.

Converting an IRA to a Roth

With a traditional IRA money can be placed into the account on a pre-tax (tax deductible) and after-tax basis.  That investment is allowed to grow on a tax-deferred basis until withdrawn in retirement.

If an individual wanted to convert a traditional IRA to a Roth IRA they had to pay federal income taxes on any pre-tax contributions as well as any growth in the investment’s value.  After all, once converted to a Roth, all of the investment could now be withdrawn on a tax-free basis in retirement.

Income Limits on Conversions

Unfortunately, that same 1997 tax law also contained a provision limiting who could make a conversion.  Upper income taxpayers – those with adjusted gross incomes of more than $100,000 – whether single or married were not eligible to make such a conversion.

In addition, if you earned $110,000 or more ($160,000 for married joint filers) then you also weren’t eligible to contribute to a Roth IRA.  These two tax laws effectively precluded upper income taxpayers from enjoying the benefits of a Roth IRA.  They couldn’t convert their traditional IRA to a Roth, and they could fund one either.

IRA Conversions in 2010

But back in May of 2006 President Bush signed a $70 billion tax cut provision that changed the eligibility rules for Roth IRA conversions.  Starting in 2010, taxpayers with modified adjusted gross income of more than $100,000 will be allowed to convert a traditional IRA to a Roth IRA.  This change applies to all years beyond 2010 – and the income taxes due on the 2010 conversion can be spread over two years.  So the 2010 conversion amount may be included as taxable income in 2011 and 2012 – helping to spread out the tax bite.  Conversions in subsequent years are included in income during the tax year in which the conversion is completed.

Removing the Roth IRA conversion cap however doesn’t mean anyone can fund a Roth IRA, but it does mean that anyone can convert an existing IRA to a Roth IRA.

Taking Advantage of the 2010 Rule

Fortunately there is a way for all taxpayers – regardless of income – to take advantage of this change in the tax code:

Start Funding a Traditional IRA Right Now!

Even if you don’t qualify to make Roth IRA contributions or traditional IRA contributions on a before-tax basis, you can still make after-tax contributions to a traditional IRA.  If you invest in a non-deductible IRA in the tax years 2006 through 2010, then you can convert those IRAs to Roth IRAs in 2010.

Most investors shy away from making non-deductible contributions to an IRA because they are not tax deductible, the investment growth is fully taxable, and because they are subject to minimum distribution rules they offer only a minimal tax shelter.  But by converting these non-deductible IRAs to Roth IRAs in 2010 many of those disadvantages disappear.

Roth IRA Conversion Examples

There is one important rule to keep in mind when it comes to converting a traditional IRA to a Roth IRA – you need to pay federal income taxes on any portion of the conversion that you haven’t already paid taxes on.

Example 1

For example, let’s say you started to fund traditional IRAs in 2006 and by 2010 you’ve got $20,000 in your account.  Furthermore, let’s say this account consisted of four years of $4,000 non-deductible contributions – a total of $16,000 in non-deductible contributions and $4,000 in account growth.

In this example, you’d need to pay income taxes on the $4,000 in fund growth when you convert to a Roth IRA.  But the good news is you’ll never have to pay income taxes on this account again.

Example 2

In this second example, let’s assume that you funded the that same traditional IRA with before-tax dollars – meaning you were able to take a deduction on your tax return for the money placed in the traditional IRA.

In this example, you haven’t paid income taxes on any of the money in the account, so when you convert it to a Roth IRA taxes are owed on the entire account balance.  In this case you’d have to pay income taxes on all $20,000 in your fund.

Example 3

If you have an existing traditional IRA (with tax-deductible contributions) and you start to fund a non-deductible IRA, then you need to be aware that tax rules state that any conversion is done on a pro-rata basis.  Let’s say you had $100,000 in a regular IRA and you had $25,000 in a non-deductible IRA.

If you wanted to convert $25,000 to a Roth, then you’d owe taxes on $20,000 because the pro-rata share of your non-deductible contributions is only $5,000.

Deciding to Fund a Roth IRA

While it might be very exciting for some individuals to learn that they can use this 2010 law to convert an IRA to a Roth IRA, it’s important to mention that Roth IRAs are not for everyone.  Before converting you might want to read our article dedicated to explaining the differences between a Roth IRA and a Traditional IRA.  You might also want to run through some what-if scenarios using our Roth versus Traditional IRA calculator.    http://www.money-zine.com/Calculators/Retirement-Calculators/Roth-vs.-Traditional-IRA-Funds-Calculator/

It’s always best to make an informed decision and if you ever have a question about what’s right in your particular situation it might be a good idea to consult with a tax professional before deciding if taking advantage of the rule change in 2010 is right for you.

“hobby-loss rule” vs profit-seeking business

IRS Seeking To Tax Your Hobby

William P. Barrett   07/10/09 	 5:30 PM ET

At a time when the federal government is desperate for revenue, the Internal Revenue Service has issued a new manual to help its agents ferret out taxpayers improperly writing off the costs of hobbies.

The latest “audit technique guide” covers the application of what is known informally as the “hobby-loss rule.” This is the Internal Revenue Code provision–Section 183–that prohibits taxpayers from reducing their taxable income through losses generated from activities conducted primarily for personal pleasure, rather than as a profit-seeking business.

The effort to focus on hobby losses is the latest in a series of IRS initiatives scrutinizing taxpayers’ side ventures. The agency has solicited comments on how to implement a new law requiring payment card companies to report sales from taxpayers selling goods over eBay.

The new hobby loss manual, which can be viewed online here (www.irs.gov/businesses/small/article/0,,id=208400,00.html), contains a long list of hobbies that the IRS deems as red flags. It includes horse and dog breeding, yacht chartering, airplane leasing, gambling, photography, fishing, stamp collecting, bowling, writing and farming.

A 2007 report by the Treasury Inspector General for Tax Administration suggested that improper hobby loss claims cost the feds billions of dollars a year in tax revenues. But the manual itself acknowledged that historically, sorting out hobby losses “has been a difficult issue to pursue.”

While the manual is intended to help IRS agents detect wrongdoing, it also provides taxpayers with a wealth of information and tips on how to pursue a hobby with the best chance of getting Uncle Sam to pick up part of the tab.

The hobby-loss rule comes into play primarily when a taxpayer claims a loss on his tax return’s Schedule C (or, if for farming, on Schedule F) for a questionable activity and that loss is then used to offset other taxable income–like from a day job or investments. What can draw the most IRS scrutiny are claims of big losses for several years in a row.

Tax rules stipulate that there is a presumption the activity is legitimate if it shows a profit, no matter how small, in three of the past five years (two years out of seven for horse breeding). One strategy taxpayers might use to fulfill this requirement is to bunch expenses together to produce three years of small profits and two years of large losses.

Keeping good records and operating in a businesslike manner can go a long way toward convincing agents the pursuit is a vocation rather than an avocation. For instance, the IRS manual tells agents to ask during a face-to-face interview if there is an existing written business plan for the activity, suggesting taxpayers would be well advised to develop one at the outset. Agents also are instructed to ask if the activity has its own bank account–something taxpayers would do well to set up before the IRS begins asking for records.

The manual specifies questions that the IRS agent should ponder: “Are there activities with large expenses and little or no income? Are losses offsetting other income on the return? Does the activity result in a large tax benefit to the taxpayer? Does the history of the activity show that it is generating any profit in any years?”

IRS regulations list nine factors that agents are to weigh in evaluating a hobby-loss situation. Among them: the manner in which the activity is carried out, the expertise of the taxpayer, the time and effort involved and “elements of personal pleasure or recreation.” The manual provides plenty of guidance for taxpayers on how to address these issues.

Under the IRS’s interpretation of the hobby-loss rule, revenue and expenses from separate, unrelated activities cannot be combined unless the undertakings are “sufficiently interconnected.” Stated factors to be considered include the “degree of organizational and economic interrelationships of various undertakings.” The manual says a taxpayer’s characterization of what constitutes a single activity will be accepted unless it is “artificial and cannot be reasonably supported.” Translation: You’re probably not going to be too successful in convincing an IRS agent that a race horse owned Upstate is part of a New York City delivery business.

Besides consulting internal, super-secret IRS databases with cryptic names like IRDS, CFOL and YK-1, the manual counsels examiners to research taxpayers on the Internet using Google and Yahoo. Information found, the manual states, “should be compared with the taxpayer’s return.” So creation of a Web site touting the activity as a business and soliciting customers could work to the taxpayer’s advantage.

The IRS seems particularly obsessed with yacht chartering. One of the few case studies in the manual lists 25 documents that should be requested of taxpayers claiming related deductions, including copies of any promotional materials used to solicit charter business.

If admonitions in the manual are any indication, the IRS has had a problem with indignant agents. “An examiner should not tell a taxpayer that, because he is involved in a particular business activity, it is not possible to make a profit and his/her losses are thereby disallowed” the manual states. “Each taxpayer is entitled to be evaluated by a fair, impartial examiner.”

At one point the manual suggests that agents attempt an end-run around tax advisers that a taxpayer might bring to an audit interview. “Direct the questions to the taxpayer,” it states.

Convincing Uncle Sam To Subsidize Your Hobby

Bunch up expenses

IRS rules presume that a side activity is a legitimate business endeavor, rather than a hobby, if it shows a profit in three of the last five years. Try to incur expenses in a way that shows small profits in three years and large losses in the other two.

Write a business plan

The IRS manual says the existence of a reasonable “formal written business plan” drafted at the outset of an activity can be a favorable factor in regarding deductions as legitimate.

Operate like a business

Maintaining good records, getting a state sales tax identification number and opening a separate bank account can be evidence of intent to run a business and show a profit.

Display personal expertise

It will help your bid to deduct those Vegas gambling losses if you can document your long wagering experience and continuing efforts to improve your knowledge, such as buying books and taking courses on mathematics and risk.

Put in the hours

The more time and effort you devote to the activity, the greater your chance of convincing IRS agents you hope to make a buck from it. Keep a written log of your activities.

Make it one big ball of wax

IRS rules state that revenues and expenses from separate side activities–say bowling and dog breeding–cannot be combined unless they are “sufficiently interconnected.” The manual states that a taxpayer’s declaration should be given some weight, especially if supported with evidence of joint economic purpose or conduct. For instance, a taxpayer might be able cast himself as a lecturer on both topics.

Have an Internet presence

Since IRS agents are advised to research taxpayers on the Internet, creating a Web site promoting your activity as a business can work in your favor.

Let your tax adviser do the talking

The manual slyly suggests that during a face-to-face audit interview with a taxpayer and his tax adviser, IRS agents direct their questions to the taxpayer–who might not know the most tax-appropriate answer and whose answer might hurt the cause. Rather than playing along, politely refer queries to your hired help.

Act in good faith

If what you’re doing is truly just a hobby from which your sole return is personal pleasure, stop right there. It’s probably not worth the effort and potential risks to save what in many cases is pocket change.


Tax Payment Options

IRS tax tips

April 8, 2009

Payment Options

If you cannot pay the full amount of taxes you owe by the April deadline, you should still file your return by the deadline and pay as much as you can to avoid penalties and interest. There are also alternative payment options to consider:

  • Additional Time to Pay Based on your circumstances, you may be granted a short additional time to pay your tax in full. The IRS is sometimes able to allow a brief additional amount of time to pay in order to facilitate tax debt repayment. A brief additional amount of time to pay can be requested through the Online Payment Agreement application at IRS.gov or by calling 800-829-1040. Taxpayers who request and are granted an additional 30 to 120 days to pay the tax in full generally will pay less in penalties and interest than if the debt were repaid through an installment agreement over a greater period of time.
  • Installment Agreement You can apply for an IRS installment agreement using our Web-based OPA application on IRS.gov. This Web-based application allows taxpayers who owe $25,000 or less in combined tax, penalties and interest to self-qualify, apply for, and receive immediate notification of approval. You can also request an installment agreement before your current tax liabilities are actually assessed by using OPA. The OPA option provides you with a simple and convenient way to establish an installment agreement and eliminates the need for personal interaction with IRS and reduces paper processing.
  • Pay by Credit Card or Debit Card You can charge your taxes on your American Express, MasterCard, Visa or Discover credit cards. Additionally, you can pay by using your debit card. However, the debit card must be a Visa Consumer Debit Card, or a NYCE, Pulse or Star Debit Card. To pay by credit card or debit card, contact one of the service providers at its telephone number or Web site listed below and follow the instructions. There is no IRS fee for credit or debit card payments, but the processing companies charge a convenience fee or flat fee. If you are paying by credit card, the service providers charge a convenience fee based on the amount you are paying. If you are paying by debit card the service providers charge a flat fee of $3.95, do not add the convenience fee or flat fee to your tax payment.

For more information about filing and paying your taxes, visit the IRS Web site at IRS.gov and choose “1040 Central” or refer to the Form 1040 Instructions or IRS Publication 17, Your Federal Income Tax. You can download forms and publications at IRS.gov or request a free copy by calling toll free 800-TAX-FORM (800-829-3676).



Phyllis Smith and Evelyn Dixon are available to prepare (or amend) your tax return

If you’re not sure your tax return was prepared correctly at your OLD tax preparation firm, or just need to speak to an experienced tax professional – call Phyllis Smith or Evelyn Dixon at 636-240-1511.  If you get an IRS notice – don’t panic and don’t delay – just give us a call.  We can unravel any errors and draft your response to an IRS correction notice.  We can also help estimate next year’s tax based on your projections of income and deductions so that you can more accurately make decisions about your withholding or estimated payments.

Welcome to Smith Tax and Bookkeeping!

We are happy to announce that Smith Tax and Bookkeeping will be open for business at 950 Bent Oak Ct. in Lake St. Louis Mo. starting on Dec. 1, 2008 Dec. 2, 2008.

Phyllis Smith and Evelyn Dixon will be available at that time to set appointments and answer any questions you may have.  We look forward to providing for your tax and bookkeeping needs with our full staff in January 2009.  Smith Tax and Bookkeeping Services Inc. is prepared to complete and electronically file individual and business income tax return, as well as process tax forms and payroll for businesses.

Phyllis Smith and Evelyn Dixon look forward to visiting again with their clients from the OLD practice.