Roth conversion changes for 2010

For 2010, some limitations for converting a regular IRA to a Roth will be eliminated. Before 2010, the conversion was prohibited when adjusted gross income excluding the conversion amount was more than $100,000. In addition, married persons filing a separate federal income tax returns couldn’t make a Roth conversion. These limitations are eliminated after 2009.

For 2010 only, taxpayers may elect to report the taxable income resulting from converting a regular IRA to a Roth IRA 50% in 2011 and 50% in 2012. Since tax rates are expected to go up, this might not be a great tax benefit.

Coming up with the money to pay the tax bill resulting from a Roth conversion will be a major hurdle when considering whether to make a conversion. To get the most benefit, all of the funds from the regular IRA should be transferred to the Roth account, but where will the money come from to pay the tax? The owner might have to have big savings or investment accounts in addition to the IRA and Roth accounts in order to pay the tax bill. Many will not be able to afford it without keeping some of the IRA distributions and being subject to early distribution penalties.

The conversion is generally accomplished using a rollover completed within 60 days after a distribution, excluding required minimum distributions from an IRA.

Most lump sum distributions from other qualified plan accounts, like 401k plans, have qualified for Roth conversions since 2008. Employer contributions to SEP and SIMPLE accounts aren’t eligible for conversion in the year the employer claims a deduction.

Since you are not required to take minimum distributions from a Roth account during your lifetime (but successors who inherit a Roth account are required to take them) and distributions from a Roth are tax free, Roths are a great vehicle for investment and can be viewed as a life insurance supplement.

(Remember that tax exempt entities like Roths and IRAs can be required to pay income taxes if they have "unrelated business income," so holding a business interest in a Roth, like leveraged rental real estate or "quick flipping" real estate, doesn’t mean the income will never be subject to income taxes. See a tax advisor for details.)

If your life expectancy (or joint life expectancy with your spouse) is short, your tax benefits of the conversion will not be as great as for those with longer life expectancies, because the conversion is a taxable event which could be stretched out with a regular IRA. On the other hand, since life expectancies are increasing, even seniors can benefit from making a conversion. Also, federal income tax rates will probably be increasing after 2010, so you might benefit from paying income taxes at current low rates.

Another "wild card" in the conversion equation is the value of the stock market. A conversion when investment values are high will result in a higher tax. It’s almost impossible to guess when the stock market will be at a high point or a low point.

You can change your mind

If a Roth conversion is made during a taxable year, it can be reversed by a trustee-to-trustee transfer to a regular IRA no later than the extended due date of the federal tax return for the year. The accumulated earnings attributable to the conversion amount are also required to be transferred to the regular IRA account to qualify as a reversal.

Using a conversion to beat Roth contribution limits

Annual Roth contributions (other than rollovers and conversions) are phased out when "modified adjusted gross income" exceeds $120,000 for singles, $176,000 for married persons filing joint returns, and $10,000 for married persons filing separate returns.

If you have no IRA accounts for previous years, you can make a $5,000 non-deductible IRA contribution for 2009 until April 15, 2010. The non-deductible IRA can then be converted to a Roth account. There may be little or no taxable income for income accumulated in the non-deductible IRA after setting it up. Effectively, the Roth contribution limits are defeated in this scenario.

If you already have "regular" IRA accounts accumulated through funding with deductible contributions in prior years and/or with rollovers from qualified plans, such as 401(k) accounts, all of the IRA accounts are treated as one account when a distribution is made. This means a Roth conversion after a non-deductible contribution to a "regular" IRA will carry out taxable income attributable to deductible contributions and rollovers from taxable retirement accounts.

Conclusion

With the elimination of Roth conversion limitations, taxpayers will have considerably more flexibility to accumulate more funds in Roth accounts. These transactions should be made under the guidance of a tax advisor who is familiar with the rules together with a financial advisor.

The answer about whether to go ahead with a Roth conversion is one you should develop together with a tax advisor considering your individual situation. (We can help—call 408-918-3162 for an appointment.)

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IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this website was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.