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HORNE Tax Alert

IRA to Roth IRA Conversion - 2010 Presents a Window of Opportunity

Beginning January 1, 2010, any taxpayer may convert a traditional IRA to a Roth IRA regardless of income level. The former rule limiting these types of conversions to taxpayers with modified adjusted gross income of $100,000 or less has been eliminated as of January 1, 2010. Additionally, married taxpayers filing a separate return will be able to convert a traditional IRA to a Roth IRA. Currently they are prohibited from doing so.

A conversion from a regular IRA to a Roth IRA is subject to tax as if it were distributed from the traditional IRA and not recontributed to another IRA. The conversion is not subject to the 10% premature distribution penalty.

Why make an IRA to Roth IRA conversion? Roth IRAs have two major advantages over regular IRAs.

1. Distributions from regular IRAs are generally taxed as ordinary income. By contrast, Roth IRA distributions are tax-free if they are "qualified distributions." To be qualified they must be made:
   • after the funds have been held in the Roth IRA account for five years
   • when the account owner is 59½-years-old or older, or on account of death, disability, or the purchase of a home by a qualified first-time homebuyer (limited to $10,000)
2. Regular IRAs are subject to the lifetime required minimum distribution (RMD) rules that generally require minimum annual distributions to be made annually after the taxpayer attains age 70½. By contrast, Roth IRAs are not subject to RMD rules.  This is a big estate planning benefit of RothIRAs.  The money can be left in the account where it can keep growing for the benefit of heirs without being reduced by income taxes and RMDs.

Who should make the IRA to Roth IRA conversion? Conversions should be considered by taxpayers who:

1. Have a number of years to go before retirement and are able to recoup the dollars that are lost to taxes on account of the conversion.
2. Anticipate being taxed in a higher bracket in the future than they are now.
3. Can pay the tax on the conversion from non-retirement account assets. Otherwise, there will be a smaller buildup of tax-free earnings in the depleted retirement account.
4. Have special favorable tax attributes including net operating losses, charitable deduction carry forwards, business tax credits, etc.

Complicating factor for 2010 conversions. A unique income inclusion rule will apply for IRA to Roth IRA conversions ocurring in 2010.  Unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010. One-half of the conversion income is able to be included in income in 2011 and the other half is included in 2012 income.

The wild card in making this decision is the tax rate picture after 2010. Absent any legislative action, the tax rates after 2010 revert to their pre-2001 levels. This means the top tax rates increase. There have been proposals on the table to help finance healthcare reform but it is difficult to predict at this time what, if any, the final changes may be.

What should be done this year? Taxpayers that want to take advantage of the new conversion option next year should consider the following strategies:

1. A taxpayer should make a deductible IRA contribution if they are eligible. This will reduce their 2009 tax bill and, if they make the conversion to a Roth IRA next year, they will not have to pay back the tax savings until 2011 and 2012.
2. High income taxpayers who have not made deductible IRA contributions in the past should consider making a nondeductible contribution this year. The conversion is generally taxable only to the extent of earnings on the nondeductible contributions. If the taxpayer has previously made deductible IRA contributions, complex rules determine the taxable amount.
3. Some high income taxpayers will make large conversions in 2010 but will opt out of the deferral of tax until 2011 and 2012, because they fear they will be in higher tax brackets in those years than in 2010. These taxpayers should avoid the standard year-end planning wisdom of accelerating deductions and deferring income but should do the reverse in an effort to avoid being pushed into the highest tax brackets by the conversion. These taxpayers should be considering ways to defer deductions to 2010 and accelerate income from next year to 2009.

What is the window of opportunity? A taxpayer may recharacterize (i.e. "undo") the Roth IRA conversion in the current year or by the extended filing date of the current year's tax return. This is the window of opportunity. For example, a taxpayer converts his traditional IRA to a Roth IRA on January 1, 2010. The taxpayer should extend the filing of his 2010 tax return to October 15, 2011. He can use this period of time to look back and see if this was a wise decision. If for whatever reason the taxpayer wishes he had not made the conversion, he can "recharacterize" the conversion from a Roth IRA back to a traditional IRA as long as it is done by October 15, 2011. The taxpayer must recharacterize all assets in the Roth IRA account. He cannot "cherry pick" and recharacterize only those assets that have declined in value. For this reason, it is wise to review the assets in the traditional IRA account and separate the highly appreciating assets from potentially risky assets. A taxpayer can convert one traditional IRA into multiple Roth IRA accounts. He can recharacterize one Roth IRA and leave the other account(s) as Roth IRAs.

HORNE's tax team is ready to help you with IRA to Roth IRA conversions. For more information, please contact your HORNE advisor or local office.