Roth IRA conversion in 2010

Roth IRA conversions are a hot topic. Effective January 1, 2010, a provision in the Tax Increase Prevention and Reconciliation Act of 2006 (TIPRA) eliminates the $100,000 limit on adjusted gross income (AGI) that previously prevented higher income taxpayers from converting a traditional individual retirement account (IRA) to a Roth IRA. This change opens up a number of retirement and tax planning opportunities for both employees and plan sponsors.

Contributions made into a Roth IRA have already been taxed; therefore when a traditional IRA is converted into a Roth IRA, the individual is required to pay taxes on the conversion amount by including it as gross income for the year the conversion occurs. One reason Roth IRA conversions are attractive is that earnings may ultimately be withdrawn tax free (as long as all requirements are met).

To be eligible for tax-free treatment, the Roth IRA must have been in existence for five years and the IRA owner must be age 59½ or older, disabled, or deceased. Another benefit is that Roth IRAs are not subject to the required minimum distribution (RMD) rules. (Note that an individual currently receiving RMDs from a traditional IRA cannot convert the current year’s RMD amount to a Roth IRA.)

Taxpayers who convert a traditional IRA into a Roth IRA in 2010 have a special opportunity for paying the income tax due on the conversion amount. Ordinarily, the taxpayer would include the total amount as income for the 2010 tax year. Under the new law, instead of paying income tax on a 2010 Roth conversion in the same year, taxpayers can opt to defer their tax burden by a year and then spread it over two years, paying equal amounts in 2011 and 2012. This relief applies only to Roth conversions in 2010.

Example: Jane decides to convert $200,000 from her traditional IRA into a Roth IRA in 2010. The next decision she must make is whether to:

§ Include the full $200,000 in gross income in 2010, or

§ Include $100,000 in gross income in 2011 and another $100,000 in 2012.

Some individuals who convert to a Roth IRA in 2010 may prefer to pay the taxes in 2010, especially if they are wary of possible tax rate increases. After 2010, those who convert to a Roth IRA will have to pay related income taxes in the year the conversion is completed. However, there’s one way taxpayers can moderate the tax burden of a Roth conversion: Instead of converting the entire value of a traditional IRA to a Roth IRA in a single tax year, they can convert smaller amounts over the course of several years.

Volatility in the investment markets can sometimes throw a wrench into the works. Fortunately, it’s possible to undo a Roth IRA conversion through a process called “recharacterization,” a popular option when the value of an individual’s account drops soon after converting to a Roth IRA. Recharacterization allows an individual to change the amount that was initially converted to a Roth IRA (with earnings) back to a traditional IRA, and the amount recharacterized remains tax deferred. Taxpayers have until the due date of their federal income-tax return (including extensions) for the year the Roth IRA conversion occurs to consider a recharacterization.

Example: John converts his $250,000 traditional IRA into a Roth IRA in February of 2008. In February of 2009, his account balance has dropped to $150,000.

If John takes no further action, he will have to include the $250,000 conversion amount as income for the 2008 tax year, even though it is now worth only $150,000. If John recharacterizes his Roth IRA back into a traditional IRA, the conversion and recharacterization will have no tax consequences for the 2008 tax year. John may convert this money to a Roth IRA at a later time.

In 2010, the AGI income restriction will still apply to Roth IRA contributions. (The limit for 2009 is $101,000, $159,000 for married joint filers.) However, those with AGI exceeding the eligibility limit will have the option of contributing to a traditional IRA and later converting it to a Roth IRA. TIPRA has generally circumnavigated the Roth IRA AGI limit for all taxpayers.