News

It is important to understand that an IRA conversion is treated as a taxable distribution, taxed as ordinary income at your marginal tax rate based on the fair market value of the assets on the date of conversion.  This in effect accelerates the taxable income that you would eventually pay on distributions from a traditional IRA once you retire, but does so in exchange for never taxing any future appreciation in the value of your account from what it is today.  That is often a significant tax advantage.  You should also note that unlike a withdrawal from an IRA, a conversion does not trigger the 10 percent early withdrawal penalty.

Although conversion to a Roth IRA does trigger immediate taxable income, Congress provided a special incentive in 2010 to jump-start Roth conversions.  In 2010 (and 2010 only), individuals will have the choice of recognizing their conversion income in 2010 or averaging it over 2011 and 2012.  This latter option, which must be elected on your 2010 income tax return, allows you to pay taxes on the converted amount ratably over two years, instead of recognizing it all as income in one year.  You will be taxed at the rates in effect for 2011 and 2012.

For some taxpayers, their tax rate may rise after 2010 even if their income does not.  President Obama has proposed, and Congress is expected to enact, legislation to restore the top two pre-2001 marginal income tax rates after 2010.  This means that the top two brackets will be 39.6 percent and 36 percent after 2010.  Consequently, if you do not want to take the chance that your income tax rate will be higher in 2011 and 2012, you may want to elect to pay the full tax on the Roth conversion in your 2010 income tax return, at 2010 income tax rates.  There is no way now to determine whether various states will also allow the tax on Roth conversion to be averaged over 2011 and 2012.

Higher-income individuals who plan to pay the entire conversion tax in 2010 instead of ratably in 2011 and 2012 because of the anticipated increase in the top marginal tax rates, may want to avoid, for year-end 2009, the traditional year-end-planning techniques of accelerating deductions and deferring income.  Alternatively, consider doing the opposite this year to avoid being pushed into the highest brackets by a large IRA-to-Roth-IRA conversion.

Taxpayers are expected to convert their traditional IRAs to Roth IRAs for a variety of reasons.  Roth IRAs have two major advantages over traditional IRAs:

·       Roth IRA distributions are tax-free if they are qualified distributions.  To be qualified, they must be made after a five-year holding period and after the accountholder reaches age 59 & 1/2 or on account of death, disability, or the qualified purchase of a first home.

·       Roth IRAs are not subject to the required minimum distribution (RMD) rules that apply to traditional IRAs (as well as individual qualified plans).  Therefore, a Roth IRA accountholder who reaches age 70 & 1/2 does not need to begin taking distributions; instead, the funds can continue to grow tax free until they are needed or are passed on to heirs who will be required to make minimum withdrawals.  A nonspouse beneficiary normally must receive the entire balance in the account within five years of the year of the owner's death, or if possible, over their life expectancy beginning no later than the end of the calendar year following the year of the owner's death.  Spouse beneficiaries can elect to treat the Roth IRA as their own or roll it into their own Roth IRAs.

The tax-free nature of qualified Roth IRA distributions may prevent individuals from being taxed in a higher tax bracket that would otherwise apply if he or she were withdrawing taxable distributions from a traditional IRA.  Moreover, these distributions – unlike those from traditional IRAs – do not affect the calculation of tax owed on Social Security payments and do not affect AGI-based deductions.

An IRA to Roth IRA conversion should be considered by individuals who:

·       Can afford to pay the tax on the converted amounts with non-IRA funds.

·       Anticipate being in a higher tax bracket in the future than they are currently in, and

·       Have a significant amount of time before reaching retirement to allow assets to grow tax-free and recoup dollars that may have been lost due to the conversion tax.

Another significant advantage of converting to a Roth IRA is the provision which allows you to "recharacterize" your conversion back to a taxable IRA.  For example, if you convert your Traditional IRA in 2010, you have until the due date for filing your 2010 income tax return, including extensions (October 15, 2011) to change your decision and have your Roth IRA account reconverted to a taxable IRA and owe no income tax whatsoever.  This would be especially applicable if the value of your account falls in value from the time at which you made the original election to convert to a Roth IRA.

There are a significant number of tax and financial considerations that come into play when determining whether to convert your traditional IRA to a Roth IRA.  You may want to go to the Resources and Financial Calculators section of our website.  If you have any questions about traditional IRA to Roth IRA conversions and the new 2010 planning opportunity, please contact our office.