Through 2009, you could convert a traditional IRA to a Roth IRA only if your modified adjusted gross income (for the year was no greater than $100,000 on a single or joint tax return. The $100,000 cap came off in January 2010. Under current law, this change is permanent. Therefore, high-income taxpayers can convert traditional IRAs to Roth IRAs in 2010, 2011, 2012, and so on. For taxpayers who would like to convert their traditional IRA to a Roth IRA, year-end 2010 presents multiple opportunities.

Example 1: Wendy Ames has $200,000 in her traditional IRA that contains only pretax dollars. Wendy would like to invest in a Roth IRA because these accounts may permit tax-free withdrawals in the future, and Roth IRA owners don’t have to take required distributions. Also, if she wishes, Wendy can leave her Roth IRA intact for her beneficiaries, who will have to take scheduled distributions but will owe no tax as long as the account is at least five years old.

Crafting a conversion

If Wendy is debating whether to convert her traditional IRA to a Roth IRA in 2010 or wait until 2011 or later, a 2010 conversion offers several advantages:

  1. Lower taxes. Although Wendy will owe tax on the amount she converts, in this example, her traditional IRA has a much lower value now than it did in 2007 because of stock market declines. Therefore, a Roth IRA conversion now would generate a lower tax obligation than it would have created three years ago.
  2. Lower tax rates. A 2010 conversion also will lock in this year’s income tax rates, which might be higher in the future.
  3. Faster tax-free withdrawals. Roth IRA withdrawals are tax-free after five years and after age 59 1/2. By converting in late 2010, Wendy will start the five year clock for tax-free withdrawals at January 1, 2010.
  4. Future flexibility. Taxpayers who convert to a Roth IRA in 2010 have a unique choice. In this example, Wendy can report the taxable income from her 2010 Roth IRA conversion on her 2010 tax return. Or she can take advantage of a special rule for 2010 conversions and report half of the income on her 2011 tax return and the remaining half on her 2012 return, thus obtaining a period of tax deferral.
  5. Surtax relief. Starting in 2013, some high-income taxpayers will owe a 3.8% surtax on investment income. (See the third quarter 2010 issue of the CPA Client Tax Letter for further details.) If Wendy converts her traditional IRA to a Roth IRA, she will not have to make required minimum distributions in the future, and she may reduce her taxable portfolio to pay the income tax on her Roth IRA conversion. Consequently, Wendy might have lower gross income and lower taxable investment income in future years, which could reduce her exposure to the 3.8% surtax. Wendy can gain thi: advantage with a Roth IRA conversion in 2011 or 2012 as well, but a 2010 conversion also will provide the other advantages on this list.

Taking action

Some taxpayers may choose to convert by year-end 2010 because they will have a chance to reverse their conversion. All Roth IRA conversions can be recharacterized by October 15 of the following year (October 17 in 2011); the account would revert to a traditional IRA, and the taxpayer would receive a refund of any tax paid on the conversion.

Example 2: Tim Bradley decides to convert his $100,000 traditional IRA to a Roth IRA in late 2010 to take advantage of a low IRA balance and today’s relatively low tax rates. He pays the tax on $100,000 of income with his 2011 tax return. In October 2011, Tim sees that his Roth IRA is worth $125,000. He decides to leave his Roth IRA in place, with $25,000 of tax-free growth in the account.

Example 3: Assume the same facts as in example 2, except that Tim’s Roth IRA has declined to $80,000 by October 2011. He recharacterizes the account to a traditional IRA and files an amended tax return for a refund. After waiting at least 31 days, Tim can reconvert this traditional IRA to a Roth IRA. If the account value has not changed materially in the interim, Tim will owe less tax on this Roth IRA conversion than he owed on his 2010 conversion.

Taxpayers who are considering a Roth IRA conversion in the last quarter of 2010 should take the following steps:

  • First, evaluate the benefits of converting your traditional IRA to a Roth IRA. If you are concerned that upper income individuals and couples will a much higher taxes in the future, you may want to convert your tax-deferred traditional IRA to a tax-free Roth IRA.
  • Second, if you would like to have a Roth IRA, decide how much you are willing to convert. If you do a partial conversion, you will reduce your tax obligation.
  • Finally, if you decide to convert your traditional IRA to a Roth IRA and you have determined how much you’d like to convert, notify the custodian of your traditional IRA in advance. There may be a rush to convert to Roth IRAs at the end of2010 as many taxpayers seek to take advantage of the benefits mentioned previously.

By notifying your IRA custodian in advance about your plans, you may be able to get your paperwork ready for a Roth IRA conversion in late 2010. If you or a loved one face a similar decision, our office can help you make an IRA plan that’s appropriate for your specific circumstances.

2010 Q4 | Year-End Tax Planning for IRAs
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