PENSCO Trust - Self Directed IRA | PLANS: Roth IRA Conversion

Roth IRA Conversion

Effective January 1^st, 2010, Roth IRA conversions are on sale! Heretofore, many Americans have been restricted from creating Roth IRAs due to the fact that they made more than $100,000 in adjusted gross income, the current limit for conversions. That restriction goes away permanently this January.

But that is only the beginning of the good news. Not only will more Americans be in a position to establish tax-free growth Roth IRAs from the conversion of their traditional IRAs or rollovers from traditional pension plans like 401(k)s, but for 2010 only, they’ll be allowed to spread the tax impact (normally payable in the tax year associated with the year of conversion) over two subsequent years (2011 and 2012). This effectively spreads a 2010 conversion tax consequence over three years (2010-2012).

Thus, if you convert in 2010, you do not have to report the tax due on your 2010 tax return, although you may elect to do so. Instead, if you do not report the taxable amount on your 2010 1040, you are allowed to report the taxable amount of the converted funds on your 2011 and 2012 tax returns. When you do, you have to split the tax liability equally between the two years (50% each year) and the total taxable amount of the converted funds has to be reported by the time of your 2012 tax return filing. This opportunity, it is important to note, goes away after 2010. While you’ll still be able to convert regardless of income after 2010, you won’t be able to defer the tax impact to subsequent years – i.e., taxes will be due in the year of conversion.

Why is this happening? Well the Government (it is no secret) needs funds, and to encourage these taxable conversions, they’re enticing savers with the extra incentive of spreading out the tax burden. Where can you reference this in the code? The lifting of the Roth conversion income restriction was initiated by the Tax Increase Prevention and Reconciliation Act of 2006 (TIPRA).

Strategies to consider

First of all, you may not want to wait until 2010 to convert if you are currently eligible (expect to make less than $100,000 AGI in 2009). Suppose you expect that your earned income will be less this year than next, and, therefore, you’re in a lower income tax bracket this year than you expect to be next. Then, you might want to convert now. Also, you may have assets that are undervalued now that you could convert this year with lower tax consequences, because you expect that they will appreciate in 2010. Either or both of these circumstances would suggest that it may be advisable to convert in 2009, i.e., sooner than later.
You may want to convert into multiple Roth IRAs for two reasons:
- You may need to reverse one or more conversions back to traditional IRAs (called re-characterizations) and having more than one Roth IRA to choose from can allow you to choose the losing Roth if some investments are doing better than others. That way your winners will continue to grow tax-free.
- It is probably best not to combine your converted traditional IRAs with Roth IRAs formed in prior years, because if you ever have to re-characterize, the calculations can be complex.
You may want to convert only a portion of your traditional IRA(s) because you may have one or more depreciated assets that are likely to appreciate in the future. Converting the assets before they appreciate will save you on taxes that would apply if you were to convert after they appreciate. Also, the overall tax burden may be too high for you if you convert all of your traditional IRA(s) in one year.
Bear in mind that there is a five year rule associated with Roth distributions. Any distribution during the five-year period starting on January 1^st of the year of your conversion, will be subject to a 10% penalty on the entire amount of the conversion (not distribution), unless the distribution is made after age 59½ or another exception applies. Also, if an individual who spread out the income inclusion over 2011 and 2012 dies before 2012, the deferred amount is includible in the year of death, unless the spouse acquires the deferred amount.