Final thoughts on 2010 Roth IRA conversions

Is sooner better than later?

Upper-income taxpayers are not permitted to make contributions to Roth IRAs. The boundary in this case for 2010 is $120,000 adjusted gross income for singles, $177,000 AGI for marrieds filing a joint return. If these taxpayers want a Roth IRA, the only route is conversion. For example, a traditional IRA may be converted to a Roth IRA by anyone, regardless of income, beginning this year.

The price of conversion is taxation at ordinary income rates, generally on the entire amount that goes into the Roth IRA. For maximum long-term benefit, the taxes should be paid from other sources, not the Roth IRA. Those under 59 ½ are eligible to convert without paying the 10% penalty on early withdrawals. However, if they dip into the IRA or Roth IRA to fund the tax liability, they could owe a 10% penalty on that amount.

The opportunity to convert to a Roth IRA does not expire at the end of the year, so in a sense, procrastination is permitted. Two advantages may accrue to those who act quickly. First, there’s the option of tax deferral, including spreading the load over two years, 2011 and 2012. Second, if Congress does allow the “Bush tax cuts” to lapse for top taxpayers, a conversion this year can be paid for at 2010’s relatively low rates.

The economic advantage of conversion has been magnified by the adoption of new taxes, beginning in 2013, to help pay for health care reform. If the tax cuts do expire, the scheduled top tax rate on investment income and dividends will be 43.4% in 2013 and later years. The top rate on wages will be 41.9%, the top rate on long-term capital gains, 23.8%. Accordingly, 2013 begins to look like the real deadline for conversion to a Roth IRA. Although the conversion itself won’t be subject to the health-care surtaxes, it would likely push the taxpayer’s other income into that range.

Conversion profiles

You are probably a good candidate for conversion to a Roth IRA if:

• You’re already in the top tax bracket, and you still will be in the future. By converting, you take advantage of this year’s 35% top rate.

• You have tax deduction carry-forwards. For example, a carry-forward of a large charitable deduction can be used to offset the tax liability on the conversion.

• You live in a state without an income tax, but you expect to move to a state that has one. Even if you are not in the top tax brackets, converting this year keeps more in your account by dodging the state income tax bullet.

• You expect your estate will have to pay federal estate taxes. Conversion to a Roth IRA will eliminate the estate tax on the deferred income tax, which will apply to a traditional IRA. Note, however, that the prognosis for the federal estate tax is uncertain at this time.

• You don’t want required minimum distributions at age 70 ½. The Roth IRA offers maximum freedom in this regard, though minimum distribution rules do apply to inherited Roth IRAs. If you are already 70 ½ or older, a conversion will not eliminate the required minimum distribution for the 2010 tax year.

Change of heart

What happens if you convert to a Roth IRA and then decide that it was a mistake? Perhaps the current tax rules will be extended for everyone, so the top rate doesn’t rise after all. Or perhaps a precipitous drop in asset values means that the tax will be far larger than if the conversion had been done later.

Whatever the reason, taxpayers are permitted to re-characterize a conversion to a Roth IRA, sending the money back to a traditional IRA. The re-characterization may occur as late as October 15 of the following year and still be effective. The Roth conversion may then be done at a future date, the later of 30 days after the re-characterization or the first day of the next tax year.

(November 2010)