2010: A Tempting Time for Roth IRA Conversions

By Robert Steere, Toolkit Staff Writer

Changes in the tax law make 2010 a particularly tempting time to think about converting your traditional IRA into a Roth IRA. The logic goes that you can save money in the long run by paying more taxes today. And with most observers agreeing that tax rates are likely to do nothing but rise after 2010, it really may be the right time to convert, if you've been considering the possibility.

The most significant change in the tax law for 2010 is that people with annual income levels above $100,000 are now eligible to take advantage of this conversion option. Previously, only those with annual income under $100,000 were eligible to convert their traditional IRAs to Roth IRAs. The second most significant feature of the law for 2010 is a two-year deferral of the payment of income taxes due as a result of the conversion. That's a new feature that everyone can take advantage of -- if they think it will help them (and that's not necessarily a sure thing).

Why convert? How does a taxpayer benefit from converting a traditional IRA into a Roth IRA? The answer lies in the nature of each form of IRA. A traditional IRA is one where you can contribute pre-tax dollars to the investment account; the income earned by the account through the years accumulates tax-free; and you only pay taxes as you draw distributions from the account in your retirement years. In short, you reduce your taxable income by the amount of your contribution in the year you contribute, you pay no tax on the investment earnings, and then you pay tax on distributions years later when your marginal tax rate is likely to be lower - a combination of significant tax payment deferral and tax liability reduction.

A Roth IRA, on the other hand, is funded with contributions of after-tax dollars; the income earned by the account, like the traditional IRA, accumulates through the years tax-free; and when you draw distributions from the account in your retirement years, the distributions are tax-free. Thus, you don't reduce taxable income by making contributions in the year you contribute, but, after that, no more tax! Investment income accrues tax-free and withdrawals during retirement are tax-free. So, while you don't get the immediate upfront tax benefits of a traditional IRA, the ongoing benefits can be greater.

If you are the owner of a traditional IRA, and you think your marginal tax rate in 2010 is lower that the marginal rate you will be subject to in your retirement years when you will be withdrawing funds from your account, conversion to a Roth IRA might make financial sense for you. Many observers are looking at the huge federal deficits, the massive and growing federal obligations for social security and Medicare and the scheduled expiration of the reduced tax rates of the past decade at the end of 2010, and are betting that income tax rates will inevitably increase to keep up with the spending demands. And higher-income taxpayers are even more likely to bear the burden of higher tax rates. This scenario presents a compelling argument for converting traditional IRAs with taxable distributions during retirement to Roth IRAs with tax-free retirement distributions. Other reasons related to estate planning may support a decision to convert, too.

The challenge of conversion. If you choose to make the conversion, you have to come up with the cash to pay the income tax liability resulting from the conversion. But taxpayers who can pay the income tax on the IRA from non-IRA funds may benefit greatly from the Roth IRA, because of the ability to enjoy greater tax-free yields from the conversion date forward.

Another catch, if you're under age 59 1/2, is that your Roth IRA must be open for at least five years before you can withdraw funds from the account penalty-free. The five-year rule doesn't apply if you're older than 59 1/2, and, once you reach that age, you can withdraw funds from the account without penalty, though you may have some tax liability. On the other hand, when you reach the age of 70 1/2, you won't have to make the "required minimum distributions" traditional IRAs are obligated to make. Thus, you can continue growing your account longer.

In short, critical decision factors include your assumptions about tax rate differentials between the year of conversion and the future years for withdrawals; your ability to use available cash to pay the income tax liability due to conversion; your expectations of need for IRA funds to meet annual living expenses; and your time horizon -- the point when you will need the use of the funds.

Optional two-year tax deferral on conversion. If you convert to a Roth IRA during 2010, you have the option of deferring the payment of the resulting income tax liability over the following two years. Although you will ultimately be taxed on the entire amount you convert, you can report half of the taxable income from the conversion on your tax return for 2011, which is due in 2012, and then report the second half of the taxable income from the conversion on your tax return for 2012, which is due in 2013. Thus, if you do the conversion in early 2010 you won't face the tax consequences for two years, and you won't have to pay the second half of the taxes until 3 years later. In the meantime, your Roth IRA will be accruing tax-free investment earnings. The only downside of deferring the tax payment on the conversion to the later years is that tax rates may be higher in 2011 and 2012 than they are in 2010.

This opportunity to convert your regular IRA to a Roth IRA is not all-or-nothing. You can convert any portion of your current IRA into a Roth IRA at any time, and you can pay the related taxes in the year of conversion. But the option to spread your tax payments over the two succeeding years is available only if you convert in 2010.

You will owe taxes on the conversion based upon the value of the IRA at the conversion date. So making the switch early in 2010 will save you money if the account value continues to grow throughout the year. Therefore, once you make the decision to convert during 2010, the sooner you convert the better.

You will also have a safety valve in case you decide that your conversion was a mistake. The IRS allows you to "recharacterize" your newly-converted Roth IRA and reconvert it to a traditional IRA if you do it in a timely fashion. You must do it (or undo, as the case may be) in the year of conversion or by the filing date for the tax return of the year of conversion. This means you may be able to recharacterize or undo your new Roth IRA as late as October 15 of the following year. Even then, a taxpayer is allowed to "reconvert" a recharacterization the later of the tax year following the original conversion OR 30 days after the recharacterization.

You can see from all of this information that the decision to convert a traditional IRA to a Roth IRA needs to be considered carefully. It is a complex calculation involving the comparison of competing financial benefits the value of which is based on assumptions. It is best to work with your tax or financial planning professional as you make this decision. It is a great opportunity for some, but not for all.

Posted February 1, 2010.