Roth IRA: 2010 rule change
On the Chinese calendar, 2010 is the Year of the Tiger. On the U.S. tax calendar, 2010 may be the Year of the Roth. Why? Because Roth IRAs become more accessible this year. The previous $100,000 income limit restricting the conversion from a traditional IRA to a Roth is repealed. Effective January 1, 2010, you may convert to a Roth no matter what your income is.
The change comes from the Tax Increase Prevention and Reconciliation Act (TIPRA), a law signed in 2006. TIPRA also eliminates the prohibition against converting to a Roth for those married taxpayers who file separate returns. Those individuals will be able to take advantage of the new rules too.
The first question to ask
Is converting a good idea? If it made sense before and you were unable to do so only because of the income limitation, the answer is probably yes. Switching gives you access to the benefits of Roth accounts. Those benefits include tax- and penalty-free distributions, both of which generally kick in once you’re 59½ and have met the five-year holding requirement.
In addition, Roths offer estate planning advantages. For example, unlike traditional IRAs, you’re not required to withdraw specified amounts from a Roth each year once you reach age 70½. The same is true when your spouse inherits the account as your designated beneficiary. Other heirs must take distributions, but the account balance can typically be withdrawn over a number of years.
The conversion to a Roth does have a cost. When you have no basis in your traditional IRA – for instance, you deducted your original contributions on prior tax returns – you’ll have to add the entire amount converted to your taxable income. The increase in income could have tax and nontax implications, such as reducing itemized deductions or affecting college financial aid.
Fortunately, TIPRA provides a one-time incentive to do a traditional to Roth IRA conversion in 2010.
The incentive works this way
If you want to do a conversion, here’s a reason to consider doing it in 2010. You do not have to include the taxable portion of the conversion in your 2010 income. Instead you are allowed to report half of the income on your 2011 tax return and the remaining half on your 2012 tax return.
The deferral gives you a multi-year period to plan for, and pay, the tax. Just be aware that taking distributions from converted funds may have tax consequences.
You can also choose to pay more quickly by making an election to report all of the conversion on your 2010 return. While prepaying seems counterintuitive, remember that present federal tax rates are set to expire December 31, 2010. Postponing income into future years could mean a bigger tax bill.
Your plans for retirement
There’s another way tax rates can affect your decision about converting. Say you intend to retire and relocate to a state with low or no income tax, and you expect the move to reduce your overall tax rate. In that case, you may decide to delay or forgo making a conversion.
Converting involves other variables too, and it’s important to weigh the pros and cons in your individual situation. Please give us a call if you would like to discuss the best strategy for you.
