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

http://finance.yahoo.com/news/TradeOffs-In-A-Roth-IRA-ibd-212553859.html?x=0&.v=1

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.

http://www.money-zine.com/Financial-Planning/Retirement/2010-Roth-IRA-Conversions/

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.