Should you consider converting to a Roth IRA in 2010?

Special tax treatment applies this year

With the lure of tax-free distributions, Roth IRAs have become popular retirement savings vehicles since their introduction in 1998. But if you are a high-income taxpayer, with adjusted gross income of $100,000 or more, you have not been able to participate in a Roth conversion until now. Beginning this year you will be able to convert all or part of a traditional IRA to a Roth IRA.

What is a Roth IRA?

A Roth is an individual retirement account in which a taxpayer can set aside after-tax income to grow tax-free. Unlike distributions from a traditional IRA, the distributions from a Roth are tax-free. But to qualify for the tax-free treatment, you must have funded the account for at least five years and be at least 59 ½ before the initial distribution.

Conversion rules

A Roth IRA conversion occurs when an individual rolls over funds from a traditional IRA, SEP-IRA, SIMPLE-IRA or qualified employer retirement plan into a Roth IRA. The taxable amount of the rollover funds must generally be included in the gross income of the taxpayer for the year in which the conversion is made.

If you make the conversion in 2010, however, you have the additional option of including half of the conversion income in your 2011 taxable income and the other half in your 2012 taxable income. Conversions occurring after 2010 will require the entire taxable amount to be included as income during the year of the conversion.

A conversion to a Roth IRA can be advantageous for many investors:

  • After meeting the minimum age and holding period requirements, earnings can be withdrawn without tax or penalty.
  • There are no required minimum distributions at age 70 ½, allowing you to leave all of it to your heirs.
  • You may be able to contribute to a Roth IRA after age 70 ½.
  • You can do a partial conversion and realize these same advantages.

Not for everyone

Not all taxpayers are ideal conversion candidates. Generally, the ideal candidates will have some or all of the following characteristics:

  • Are financially comfortable
  • Have money outside of the converted Roth IRA to pay the income taxes
  • Are young or have low income now
  • Believe their tax bracket will be the same or higher in retirement as it is now
  • Won’t need to draw income from the Roth IRA account
  • Won’t increase their current marginal tax bracket due to the conversion

A conversion may be less attractive for taxpayers who:

  • Believe that they will be in a lower tax bracket in retirement
  • Are interested in leaving their IRA to charity
  • Are unwilling to pay the income taxes now rather than later

Can a Roth conversion be reversed?

You may decide that it is in your best interest to reverse the conversion, perhaps due to a decline in the value of your Roth account. For example, let’s say you converted a $100,000 IRA to a Roth IRA this year, but several months later it is worth only $60,000. Without “re-characterizing” (or reversing) the conversion, you would be paying income taxes on $40,000 of value that no longer exists.

Within a limited timeframe, you can re-characterize the Roth back to a traditional IRA. You will have until October 15th of the year following the conversion to reverse it. Therefore, if you converted to a Roth in 2010, you have until October 15, 2011 (the due date of your tax return plus extensions), to reverse the transaction. If you wait until after the October 15 deadline to re-characterize, you will pay taxes and penalties on any early distributions.

Is a Roth conversion right for you?

The answer depends on many factors, including your current and future income tax rates, the length of time you can leave the funds in the Roth, whether you have outside funds to pay the income taxes on the conversion, and what you want to do with the Roth IRA assets. If you make a Roth conversion and it turns out not to be advantageous, IRS rules allow you to undo the conversion within certain time limits. For many taxpayers, the new rules governing the Roth IRA income limits in 2010 represent a window of opportunity.

Your tax professional can help you decide whether a Roth conversion is right for you.

By Stephen High, CPA, JD, PFS of Kraft Asset Management, an independent founding member of Bright Sky Group.


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