Get Ready for Liberalized IRA-to-Roth-IRA Conversions in 2010

Next year will be a pivotal one for retirement planning, as it will be the first year in which taxpayers will be able to convert funds in regular IRAs (as well as qualified retirement plans) to Roth IRAs regardless of their income level. 

This new conversion option poses significant tax planning challenges and opportunities for 2009, 2010 and 2011.  Presently (in 2009), taxpayers with modified adjusted gross income (AGI) (1) in excess of $100,000 may not convert investments in traditional IRAs into investments in Roth IRAs.  This includes converting amounts from SEP-IRAs or SIMPLE IRAs.

There are two big advantages of the Roth IRA: all future earnings and distributions at retirement will be tax-free, and the Roth IRAs are not subject to the required minimum distribution rules.  Although conversions are taxable, except for previously nondeductible amounts, they are not subject to the 10% premature distribution tax. 

Big Changes Coming Next Year - For tax years beginning after 2009, the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated. Additionally, married taxpayers filing separate returns will be able to convert amounts in a traditional IRA into a Roth IRA (currently, they are barred from doing so).

There are other tax advantages. 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 were withdrawing taxable distributions, which do not enter into the calculation of tax owed on Social Security payments, and have no effect on AGI-based deductions.  Even better, 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? 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 non-taxed retirement funds.

Complicating Factor for 2010 Conversions - A unique income inclusion rule will apply for IRA-to-Roth-IRA conversions occurring in 2010. Unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010; 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. 

What to Do This Year - Taxpayers who intend to take advantage of the new conversion option next year should consider the following strategies:

• Non-high-income taxpayers who are able to make deductible IRA contributions this year should do so. They will reduce their 2009 tax bill and, if they make the conversion to a Roth IRA next year, they won't have to pay back the tax savings until 2011 and 2012.

• High-income taxpayers should consider making nondeductible IRA contributions this year. They can then roll over the accounts into Roth IRAs next year at no tax cost.

• High-income taxpayers planning to make large conversions in 2010, and pay the tax in 2010 rather than deferring the tax until 2011 and 2012, should avoid the standard year-end-planning wisdom of accelerating deductions and deferring income.  Instead, they should consider doing the reverse, accelerating income into 2009 and deferring deductions until 2010 to help reduce the conversion tax in 2010.

Conversions can be tricky!  So if you are considering a conversion in 2010, it might be appropriate to call for an appointment so this office can help you properly analyze your conversion options.

(1) With respect to conversions to Roth IRAs, the AGI is modified by eliminating a number of income exclusions, but does not include the income resulting from the conversion itself, nor does it include any required minimum distributions.

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