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The great Roth IRA conversion rush of 2010 is on. Now that there is no longer an income limit on conversion eligibility, switching money from a Traditional IRA to a Roth IRA is shaping up as the big investment trend of the year. Vanguard reports that the number of conversions it handled for January was equal to 70 percent of the total conversions the fund group processed in all 12 months of 2009.
The allure is easy to grasp. Convert today and the money that lands in your Roth IRA will be tax-free in retirement. Leave it in the traditional IRA and you face income tax on 100 percent of your retirement withdrawals (assuming none of your contributions were non-deductible.) Moreover, you will indeed be forced to make withdrawals from a Traditional IRA in retirement, as they fall under the Required Minimum Distribution rule that comes into play once you hit age 70 Â½. Money in a Roth IRA is shielded from the RMD rule; you don't have to touch the money if you don't want to.
But for all its obvious charms, the Roth conversion decision requires careful handling. Any amount that you convert today becomes part of your Adjusted Gross Income for the year of the conversion. And that's where things can get interesting:
Watch out for Tax-Bracket Creep The amount you convert is added to your tax bill as income. Convert a large sum and it could push you into a higher tax bracket . Check out the brackets for the 2010 tax year:
Source: Tax Policy Center
A workaround is to convert smaller sums over a few years, rather than one big lump-sum move in a single year.
Delaying Your Tax Bill May Cost You More. For conversions made in 2010 the IRS is offering a seemingly sweet deal: you can delay and spread your tax liability over two years. Instead of piling 100 percent of a 2010 conversion into your 2010 AGI, you can instead report half of the 2010 conversion amount as income in 2011 and the other half is added to your 2012 AGI. But if you're currently in the 33 percent or 35 percent tax brackets you might want to pay tax sooner rather than later. President Obama's 2011 budget proposes returning those two brackets to their pre-Bush-tax-cut levels of 36 percent and 39.6 percent.
Don't Blow Your Tax Credit Eligibility. If you plan to take advantage of the Homebuyer Tax Credits in 2010 make sure your Roth conversion doesn't push your AGI over the eligibility limits for those credits. Singles with AGI below $125,000 and married couples with AGI below $225,000 are eligible for the maximum $8,000 tax credit for first-time purchases in contract by April 30 (and closed by June 30th.) A reduced credit is available for single filers with AGI between $125,000-$145,000 and married couples with AGI between $225,000-$275,000. Above those upper limits you lose the buyer credit. The same income limits apply to homeowners who want to take advantage of the $6,500 credit if you trade into a new home.
You have two solid workarounds if you are at risk of a conversion pushing your AGI too high. You can simply wait to convert until 2011. Or you can convert this year, but take advantage of the IRS option to delay reporting the income until 2011 and 2012.
Clearly conversions come with plenty of moving pieces that can create unanticipated tax headaches. If any of the above scenarios apply to you, make sure you huddle with a trusted tax advisor before you make a move. You can also get a sense of how some of the tax scenarios might play out by fiddling with this Roth IRA Conversion Calculator.
If the Market Drops Consider a Recharacterization. Keep in mind that once you convert your tax liability is locked in. If you convert $100,000 you will owe tax on that $100,000, whether you pay it on your 2010 tax bill, or spread it out over the 2011 and 2012 tax bills. If the market subsequently takes a header and your account falls to $80,000 your tax liability is still $100,000. That's where an IRA Recharacterization can come to the rescue. This move allows you to undo your Roth conversion by moving the money back into a Traditional IRA and thus wiping out your original conversion tax bill. You have up until October 15th of the year following your conversion to make this move. So for 2010 conversions you can recharacterize until October 15th 2011, the tax filing deadline for 2010 assuming you have filed for extensions. If there's a big market correction between now and then, another huddle with your tax advisor could be money well spent.