Does a Roth Conversion Make Sense Next Year?

 

Next year, however, is a whole new ball game. Any individual, regardless of income level, can seize the benefits of Roth IRAs. In addition, Congress sweetened the deal by allowing for a deferral and spreading of any income tax due on a Roth conversion.

 

 

In 2009, married taxpayers filing jointly generally cannot contribute to a Roth IRA if their modified AGI (MAGI) exceeds $176,000. Similarly, single and married taxpayers filing jointly may not convert an existing IRA to a Roth IRA if their MAGI exceeds $100,000. Married taxpayers filing separately may not convert to a Roth regardless of their income level.

 

In 2010, anyone may convert traditional IRAs (including SEP IRAs and SIMPLE IRAs after participating in the SIMPLE for at least two years) to Roth IRAs regardless of income level and filing status. You must recognize ordinary income for the amount of any previously deducted contributions and any earnings on those contributions. However, for 2010 conversions that income can be reported over two years: 2011 and 2012. You may also elect to report all the income in 2010 which may be more beneficial if rates increase in 2012 as expected.

 

For example, assume your existing IRA is worth $500,000 on January 1, 2010. This balance consists entirely of deductible contributions and earnings. In 2010, you may convert the entire balance to a Roth IRA, regardless of your 2010 income. You will then report $250,000 of ordinary income in 2011 and 2012.

 

If you have not previously contributed or converted money to a Roth IRA, the five-year holding period for tax-free Roth IRA distributions begins on January 1, 2010. Going forward, however, you can enjoy all the benefits of a Roth IRA over a traditional IRA.

 

 

Higher income taxpayers normally are excluded from the making deductible IRA contributions. When married taxpayers or their spouses are covered by a retirement plan, deductible contributions to both traditional IRAs and Roth IRAs are prohibited once MAGI exceeds $176,000 (the same limit discussed above). However, these same taxpayers are free to make nondeductible IRA contributions, regardless of their income level and/or participation in a retirement plan. Historically, the attraction for making nondeductible contributions was tax-free build up of the IRA. Now, however, you may obtain greater benefits by converting your nondeductible IRA to a Roth IRA in 2010 under the rules discussed above.

 

Because IRA contributions must be made by the unextended due date of the individual’s tax return, a nondeductible contribution cannot be made for 2008. However, nondeductible contributions can be made for 2009 anytime before April 15, 2010. The maximum contribution to a nondeductible IRA is the lesser of $5,000 or 100% of the individual’s compensation. For married couples, IRA contributions of up to $5,000 can be made for each spouse if the combined compensation of both spouses is at least the contributed amount and they file a joint return. After 2008, the $5,000 annual contribution limit is adjusted annually for inflation, but only in increments of $500. Individuals who are at least age 50 by the end of the tax year, can contribute an additional $1,000 as a “make up contribution.”

 

If you plan to take advantage of the conversion strategy, you probably will benefit by maximizing the funds that can go in the Roth IRA by funding a nondeductible IRA in 2009.

 

 

A Roth conversion presents many benefits, but also carries some pitfalls. Most notably, a conversion creates an income tax liability upon the conversion. Next year offers a slight reprieve in that you can pay the tax over two years: 2011 and 2012. Alternatively, you can make a special election to report the income in 2010 which may be beneficial if tax rates increase after 2010. In addition, several risks should be considered such as: account values decrease due to market conditions; unexpected expenses require distributions earlier than intended; and the future of income tax rates. Most experts concur that income tax rates will rise in the future, but nothing is certain.

 

 

If you intend to take advantage of the new conversion rules, you can help yourself in 2009. If eligible, consider deductible IRA contributions in 2009. This will reduce your current taxes and, following a 2010 conversion, you don't pay back the tax savings until 2011 and 2012.

 

If ineligible for deductible contributions, consider contributions of up to $5,000 ($6,000 if over 50 years old) to nondeductible IRAs. You can convert these amounts in 2010 to a Roth, and only pay tax (again in 2011 and 2012) on any earnings rolled over.