Why You Should Convert to a Roth IRA in 2010

2010 offers us some special and unique planning opportunities. It allows all taxpayers to convert IRA (tax deferred) money to Roth IRAs (tax free money) regardless of adjusted gross income. In the prior years, only taxpayers with adjusted gross income of less than $100,000 were allowed to convert IRA money to a Roth IRA.

When a taxpayer converts money from a regular IRA to a Roth IRA there is a tax bill due. The taxes are based on the amount of conversion and taxed at the taxpayer’s current tax bracket. In other words, if $10,000 of regular IRA money is converted to a Roth and the taxpayer is in a 15% tax bracket, then $1500 of federal taxes would be owed in addition to state taxes.

2010 also offers another special situation in that the federal taxes owed for conversions in 2010 can be spread over 2 years rather than all being paid in one year. So, if we look at the same example above, the $1500 in taxes could be paid in 4/15/11 and 4/15/12. However, please note that if the tax brackets are higher in the later years, you will pay more in taxes. So, if you believe that we will see higher taxes down the road, it might make more sense to pay the entire tax bill in 4/15/11!

The entire IRA does not need to be converted. So, if a taxpayer has a $100,000 IRA but does not want to convert the entire IRA because of the high tax bill, he /she can convert just a portion of the IRA. And pay taxes only on the converted amount.

If there are non deductible contributions in the IRA account mixed in with deductible contributions, you cannot just convert the non deductible amounts. It must be pro-rated. Assume that a taxpayer has a $100,000 IRA and $40,000 is from non deductible or post tax contributions, then only 40% is non taxable if the entire IRA is converted. The other $60,000 would be taxable. If the same taxpayer decided to just convert $50,000, then $20,000 (40%) would be non taxable and $30,000 would be taxable.

And the final good news sounds like a TV commercial “if for any reason you are not satisfied, you can undo your Roth conversion absolutely free, with no further obligation”. It’s called a recharacterization and if you convert this year you have until 10/15/2011 to undo the conversion. For example, assume you convert $100,000 in 2010 and the market totally tanks and you end up with only $80,000 in your Roth but will owe taxes on the $100,000 that you converted. You can do a recharacterization and put the money back into your IRA and undo the whole transaction. Sounds almost too good to be true!

The earlier that you convert, the better off you will be. Consider that, over time, stocks have risen more than they have fallen. All other things being equal, converting earlier means that the dollar amount of your conversion will be lower, thereby costing you less in taxes.