2010 Liberalized IRA-to-Roth IRA Conversionsby Lee Reams in Retirement Planning
Beginning this year, taxpayers are able to convert funds in regular IRAs (as well as qualified retirement plans) to Roth IRAs regardless of their income level. Prior to 2010, taxpayers could not make a conversion if their gross income was in excess of $100,000.
Roth IRAs provide two big advantages: all future earnings and distributions at retirement will be tax-free, and the Roth IRAs are not subject to the required minimum distribution rules.
There are other tax advantages as well. Because distributions from Roth IRAs are tax-free (if they are qualified distributions), they may keep a taxpayer from being taxed in a higher tax bracket than would otherwise apply if he or she were withdrawing taxable distributions, don’t enter into the calculation of tax owed on Social Security payments, and have no effect on AGI-based deductions and credits. What’s more, the benefits flow through to beneficiaries of Roth IRA accounts, who also can make tax-free withdrawals from such accounts (they are, however, subject to the same annual post-death minimum distribution rules that apply to beneficiaries of regular IRAs).
Should You Make an IRA-to-Roth IRA Conversion? Everyone’s financial circumstances are unique and it may not be an appropriate choice in your situation. It can also be a tough decision because the conversions are taxable, except for non-deductible amounts. Thus, to gain the benefits in the future, a tax hit must be taken now.
Generally, taxpayers with the following tax profiles should consider making a conversion:
- Taxpayers that still have a number of years to go before retirement and time to recoup the conversion tax dollars;
- Are in a lower than normal tax bracket in the year of conversion;
- Anticipate being taxed in a higher bracket in the future; and
- Can pay the tax on the conversion from funds other than pre-tax retirement funds.
Special Rules for 2010 – Although conversions, without income limitations, can be made in any year after 2009, Congress has provided a unique income inclusion rule that applies for IRA-to-Roth-IRA conversions occurring in 2010. Under this rule, unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010. Instead, half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012. This requires some careful planning since, without Congressional action, the current lower tax brackets of 35%, 33%, 28% and 25% will revert to their pre-2001 levels of 39.6%, 36%, 31% and 28% after 2010. So it may be less costly for certain taxpayers to opt out of paying the tax in 2011 and 2012 and instead pay it in 2010.
These are additional items to take into consideration:
- It might be appropriate for you to design your own custom conversion plan over a number of years rather than to convert everything at once.
- Where does the money to pay the conversion tax come from? Generally, it must be from separate funds. If it is taken from the IRA being converted, then for individuals under age 59½ the funds withdrawn to pay the tax will also be subject to the 10% early distribution penalty in addition to being taxed.
Conversions can be tricky! If you are considering a conversion, it might be appropriate to call one of our tax professionals for an appointment so they can help you properly analyze your conversion options.
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