Effective in 2010, all taxpayers, regardless of the amount of their adjusted gross income (AGI), can convert a traditional individual retirement account (IRA) to a Roth IRA. Amounts converted must be included in income if taxable when withdrawn (i.e., contributions and earnings in deductible IRAs and earnings in nondeductible IRAs), but they are exempt from the 10% early withdrawal penalty.
If you make a conversion in 2010, the tax can be paid in two installments in 2011 and 2012, with no tax due in 2010. However, if you prefer, you can elect to pay the tax in 2010, which may make sense if the current lower tax rates are not extended beyond 2010 or you expect much higher income in 2011 or 2012. Taxes on conversions made after 2010 must be paid in the year of conversion.
The question is whether it makes financial sense to pay what could be a large income tax bill now to avoid any future income taxes on your IRA. Several factors need to be considered before answering that question:
What is your income tax bracket now, and what will it be when the funds are distributed? If your tax bracket will be the same at both times, the financial results will be similar. Increasing income tax brackets generally make it advantageous to convert to a Roth IRA, since you are paying the tax bill while income tax rates are lower. Decreasing tax brackets generally favor leaving the balance in the traditional IRA.
How will you pay the income taxes due from the conversion? If you can pay the tax bill from sources outside your IRA, that is a strong factor in favor of conversion. By doing so, you are in essence making an additional contribution to the IRA in the amount of the tax paid. Conversely, paying the tax bill from your IRA account can be a strong factor against converting, since you are withdrawing funds from your IRA and may also have to pay a 10% penalty on that withdrawal.
When will you make withdrawals from your IRA? If you'll make withdrawals within five or 10 years of converting, that may not be enough time for the benefits of tax-free compounding to compensate for the current payment of income taxes. But if you don't need to make withdrawals, your balance in a Roth IRA can grow tax free for a longer time, since you don't have to make required minimum distributions after age 70 1/2.
How will the income from the conversion affect your overall tax situation? That additional income could raise your overall income to a point where you lose some tax credits, deductions, or exemptions in the year of conversion.
Will your Social Security benefits be subject to taxes? In the year of conversion, the income from the conversion may affect your Social Security benefits. However, going forward, distributions from Roth IRAs are excluded from taxable income, while distributions from traditional IRAs may affect your benefits.
Are you interested in other estate planning considerations? Paying income taxes currently means that you remove those assets from your taxable estate, thus reducing estate taxes owed at your death. If you plan to leave the IRA balance to your heirs, they receive the Roth IRA proceeds free of income taxes, while income taxes would be due on the traditional IRA. Also, if you don't take withdrawals from the Roth IRA after age 70 1/2, you may end up leaving your heirs with a much larger balance.
After considering all of these factors, you can decide whether converting makes sense for your situation. Keep in mind that you do not have to convert your entire IRA balance at one time. You can convert over a number of years or only convert a portion of your IRA balance. However, be aware that if you have both deductible and nondeductible IRA balances, you cannot just convert the nondeductible balances to reduce your tax liability. You have to assume a pro-rated portion of both the deductible and nondeductible IRA funds are being converted.
Know When to Recharacterize
If you convert and your investments then decline, you end up paying taxes on more than the current market value. However, you can then recharacterize your conversion. For conversions made in 2010, you can recharacterize until October 15, 2011, meaning you can convert back to your original IRA. After the recharacterization, it is as if you did not convert, so you owe no taxes. You can then reconvert at the later of 30 days after the recharacterization or the beginning of the tax year following the first conversion.
You can recharacterize just a portion of the conversion. However, if you have several investments in the IRA, you can't simply choose the ones with the largest losses. In that situation, a pro-rated portion of all the investments in the account will be considered in the recharacterization. You can bypass this rule by setting up separate Roth IRA accounts for each investment. Then, if one declines substantially, you can recharacterize that one Roth IRA account, leaving the other accounts intact.
Roth IRA Contributions
This new conversion provision effectively removes the income limitations for contributions to a Roth IRA. In 2010, Roth IRA contributions can be made by single taxpayers with AGI less than $105,000 (contributions are phased out with AGI between $105,000 and $120,000) and by married couples filing jointly with AGI less than $167,000 (contributions are phased out with AGI between $167,000 and $177,000). It doesn't matter whether you participate in a company-sponsored pension plan. Individuals with incomes over the limits can make contributions to a nondeductible traditional IRA and then immediately convert the balance to a Roth IRA. However, keep in mind that if you have other deductible IRA balances, you will have to assume a pro-rated portion of both the deductible and nondeductible IRA funds are being converted.