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December, 2009 Tax Tip

Think About Roth Conversions When Doing Your Year-end Tax Planning


The potential tax benefits that will become available in 2010 to those with traditional IRA accounts have received much attention recently, but in case you are not aware of it, here goes.


Through 2009 there have been some tough tax rules that have prevented many higher income people from converting their regular IRA’s into Roth IRA’s.  The major historic advantage in a Roth IRA is that distributions are generally not taxable.  Therefore, even though contributions are not deductible, distributions of earnings and appreciation are not includible in taxable income.


Thanks to a 2006 tax law, beginning in 2010, restrictions have been lifted on income limits that heretofore prevented IRA owners from converting.  The old $100,000 AGI limit has been repealed for 2010 and forward!


There is another terrific reason to consider a conversion in 2010.  Except in the first year that Roth’s came into being (1998), there has been a requirement that you treat the amount in your regular IRA as a taxable distribution in the year of conversion and pay the tax on it.  Note:  In 1998 there was a one-time rule that allowed the income from a conversion to be spread evenly over four years.  Thus consideration had to be given (and still does) as to whether the earlier payment of the tax is outweighed by the advantage of receiving future appreciation and accumulated earnings tax free.


 However, the sweetener in the deal (good for 2010 only) is that the tax hit can be deferred and paid in equal installments in 2011 and 2012.  We don’t know what tax rates will be for 2011. 2012, or later, but we do know that the current rates expire after 2010 and they will undoubtedly be higher, possibly significantly.  Therefore, it would seemingly make good sense to do a conversion and lock in the lower tax in 2010, which would be paid the following two years.   I would think this is something that you would want to consider when you get together with your tax professional in the next few weeks to do your year-end work.


There is yet another thing for you to consider.  You can actually change your mind after you do a conversion if you find it wasn’t right for you!  You can undo it for any reason.  In fact, you have until October 15th of the year following the year you do the conversion to change your mind.  This is called a recharacterization.  If you choose to recharacterize it is as though the conversion never occurred.  It may be unlikely that you would change your mind since you can withdraw your money tax free when you are 59 ½ and your account has been open for five years and your objective would be to accumulate as much as possible as long as you wish (there are no required minimum distributions from a Roth).  One reason you may change your mind is if your IRA investments decline after you convert.  As your taxes from a conversion are based on the value of your account, you may wish to reverse it.


You should be aware of one final option you have   If you convert to a Roth, change your mind later and recharacterize, and then find that you want to convert after all.  This might happen if the value of your IRA investments decline after you recharacterize.  You can indeed have a second bite of the apple!  The term for this is reconverting.  It would allow you to fund your Roth one more time and pay the taxes on what would be a lower portfolio value.  Just remember, 2010 is the only year you can convert and get the two-year deferral of the tax.


Lots to think about, but the benefits can be quite significant!




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