Presto-change-o: Turn your IRA into a Roth!
On Jan. 1, 2010, anyone may transfer funds from an IRA account to a Roth IRA, thanks to a key provision of the Pension Protection Act.
Until now, only taxpayers with an Adjusted Gross Income (AGI) of $100,000 or less have been allowed to convert funds from their IRA into a Roth IRA. When IRA funds are converted to a Roth IRA, taxes must be paid on the amount of (pre-tax) IRA contributions that are converted. Another "gift" from the Pension Protection Act, however, is the ability to delay this tax liability on funds converted in 2010.
In 2010, if you convert $100,000 of taxable assets from your IRA to your Roth IRA, you may choose to pay taxes on an additional $100,000 of income for tax year 2010. However, you also have the option of paying no additional income taxes on the converted amount in 2010. Instead, you may pay income taxes on half ($50,000) of the income in tax year 2011 and half in tax year 2012.
After 2010, you may continue to convert IRA funds to Roth IRA funds, regardless of income. However, from 2011 on, taxes on the converted taxable amount must be paid in the tax year during which the conversion is made.
Are there any reasons to not use the three-year option for a 2010 Roth conversion? An obvious reason would be if you have very little income in 2010 and expect significantly more income in 2011 and 2012. A less obvious reason may be the possibility of future federal income tax increases.
The current administration has proclaimed that it will raise taxes on the "rich," which it defines as couples with incomes of $250k or more. One way this will be accomplished is by allowing the current "tax cuts" to expire at the end of 2010. When these tax cuts expire, income taxes on all income level will rise in 2011 and beyond.
Since 2010 is an election year, Congress may not be anxious to pass additional tax increases in 2010. However, with our enormous and increasing budget deficit, a tax increase in 2011 appears likely.
Depending upon your expected income in 2010 - 2012, you could pay less in taxes on your IRA to Roth IRA conversion by declaring the full amount of income in 2010, especially if income taxes increase dramatically in 2011 and beyond.
If you are considering retirement in the near future, it may be beneficial to retire at the end of 2010. This could allow you to convert a substantial amount of IRA savings into a Roth IRA. With the three year option, the Roth conversions would be taxed in 2011 and 2012, when work related income has ceased. This approach could minimize the amount of taxes owed on the Roth IRA conversion.
Do not do an IRA to Roth IRA conversions without having enough funds, outside of the IRA, to pay the taxes owed. If the taxes are taken out of the IRA, advantages of a Roth conversion will be substantially lost.
When IRA funds are used to pay the taxes owed on the conversion: 1) taxes are paid on funds being used to pay taxes 2) If you are under 59 ½, a 10 percent penalty will be assessed on IRA funds that are used to pay taxes and 3) the tax deferred and tax free account funds are reduced in value by the amount of taxes and penalties paid.
Next year provides an opportunity for millions of new taxpayers to consider the advantages of converting IRA funds into a Roth IRA. If you are unsure of whether this conversion would be beneficial, talk to your financial planner or tax accountant.