ABC Taxes, Tips & Tools

It is a spe­cial time for peo­ple con­sid­er­ing con­vert­ing their IRA into a Roth IRA. Why?

• Because the fed­eral gov­ern­ment is allow­ing tax­pay­ers to split their tra­di­tion IRA into 2 parts and pay the tax on a Roth Con­ver­sion over 2 years
• And because the restric­tions against high income tax­pay­ers has been removed
• And because the econ­omy is still in the tank so IRA val­u­a­tions are lower than they have been, and tax­pay­ers may be earn­ing less in this year than years preceding.

What is the dif­fer­ence between a Tra­di­tional and Roth IRA?

• Income con­tributed to a Tra­di­tional IRA is usu­ally pre-tax income, but Roth IRA con­tri­bu­tions are after-tax income;  there­fore all ordi­nary dis­tri­b­u­tions from a Tra­di­tional IRA are tax­able, but the ordi­nary dis­tri­b­u­tions from a Roth IRA includ­ing inter­est and div­i­dends earned are not taxable.
• Tra­di­tional IRAs can only be accessed with­out penalty upon reach­ing age 59 ½ or retir­ing or under a hand­ful of other very spe­cific sit­u­a­tions.  The amounts the tax­payer con­tributes to a Roth IRA can be accessed with­out penalty after 5 years; only the inter­est can’t be accessed until retire­ment age.
• Tax­pay­ers are not required to take min­i­mum dis­tri­b­u­tions from a Roth IRA upon reach­ing age 70 ½.

Why would a tax­payer con­sider doing the con­ver­sion now? If they think it will save them taxes in the long run.  Many fac­tors come into play.  Will tax rates go up for the tax­payer or down? Are they going to need the money in short order or will it be sit­ting in an account gath­er­ing inter­est and div­i­dends tax-free.  Can they pay the tax now?

Whether or not a Roth con­ver­sion makes sense must be han­dled on a case by case basis.  Rea­sons why it might not make sense are:

• If the taxpayer’s time-line to retire­ment date is too short to make pay­ing the taxes now worthwhile-this time­line should be at least 10 years as the longer the Roth grows tax-free the more advan­ta­geous the conversion,
• If the tax­payer expects their retire­ment income to be sub­stan­tially less than it is right now-making the con­ver­sion now could cost the tax­payer a lot more in income tax.
• If the tax­payer can’t pay the tax now from non IRA sources, Remem­ber if the tax­payer uses part of the money from the Tra­di­tional IRA to pay the taxes on the con­ver­sion, that amount is sub­ject to the 10 Per­cent Penalty for Early Withdrawal.
• Many items of adjust­ment and credit are tied to the taxpayer’s AGI.  Adding IRA income to the tax­pay­ers cur­rent income base, may cause them to lose these cred­its and adjust­ments to income.  This year there are a cou­ple of big ones: the First-time Home­buy­ers Credit and the Amer­i­can Oppor­tu­nity Credit.
• Fur­ther­more for a retired tax­payer, the con­ver­sion can make part of their Social Secu­rity tax­able and increase their medicare Part B pre­mi­ums by increas­ing income for the tax years of the con­ver­sion.  But remem­ber — once the con­ver­sion is made these seniors will not have to take min­i­mum dis­tri­b­u­tions from their Roth IRAs.

If the tax­payer decides it is advan­ta­geous to make the Roth Con­ver­sion now, they will only have to pay the tax on the con­verted amounts; there is no early with­drawal penalty. Con­vert­ing a Tra­di­tional IRA is an all or noth­ing sce­nario though. In most years the tax­payer had to come up with all the tax due for a Tra­di­tional IRA to Roth Con­ver­sion in one year.  How­ever for tax years 2010 and 2011 the tax­payer will be allowed to split their Tra­di­tional IRA and pay the tax on the con­ver­sion over two years.  As with all Roth con­ver­sions the tax­payer will have the option to reverse the 2010 con­ver­sion by Octo­ber 15, 2011 (assum­ing they timely file or file for an exten­sion and timely pay their taxes).  The tax for the por­tion of the 2010 con­ver­sion will be due in 2011 and the tax due on the 2011 por­tion will be due in 2012.

Because a per­son can re-characterize the con­ver­sion as late as Octo­ber next year, it makes sense that any­one who is con­sid­er­ing the con­ver­sion do so now rather than later, espe­cially if the account is still beaten down from hits the econ­omy has taken over the last sev­eral years.  If the IRAs value goes up over the next year, then the rise will be attrib­ut­able to gains in a Roth IRA instead of a tra­di­tional IRA. If it goes down the tax­payer can re-characterize the con­ver­sion if they want.  The tax­payer gets a do-over.  How­ever tax­pay­ers should be aware they can’t flip back and forth many times in one year, the con­ver­sion and do-over is a one-shot deal in a given tax year.

NOTE: This con­ver­sion is also avail­able for amounts in employer retire­ment plans but par­tic­i­pants in a SIMPLE plan must make sure they don’t fall afoul the 2-year hold­ing period for those plans.

If you decide a Roth Con­ver­sion is right for you, hire an advi­sor who has spe­cial­ized knowl­edge in this area.

As always, small busi­ness ser­vices and tax­a­tion are our busi­ness.  If you need help Please give Art & Busi­ness Con­sult­ing a call.  We would love to engage you as a client.

The usual dis­claimers: Although ABC has made every effort to insure the accu­racy of Taxes, Tips and Tools, mis­in­for­ma­tion, dis­in­for­ma­tion, changes, mis­takes, typos and hack­ers hap­pen, there­fore Art & Busi­ness Con­sult­ing LLC takes no respon­si­bil­ity for any action taken or results based on the infor­ma­tion sup­plied here in.  Inter­nal Rev­enue Ser­vice Cir­cu­lar 230 Dis­clo­sure:  As pro­vided for in Trea­sury reg­u­la­tions, advice (if any) relat­ing to fed­eral taxes that is con­tained in this com­mu­ni­ca­tion (includ­ing attach­ments) is not intended or writ­ten to be used, and can­not be used for the pur­pose of (1) avoid­ing penal­ties under the Inter­nal Rev­enue Code or (2) pro­mot­ing, mar­ket­ing or rec­om­mend­ing to another party any plan or arrange­ment address herein.  Art & Busi­ness Con­sult­ing LLC cur­rently does not have a cer­ti­fied pub­lic accoun­tant or an attor­ney on staff; this infor­ma­tion is purely for edu­ca­tional pur­poses and not to be con­strued as legal or finan­cial advice.  Art & Busi­ness Con­sult­ing LLC and its employ­ees, mem­bers and asso­ciates are not engage to prac­tice law; you always should dis­cuss legal mat­ters with your attor­ney before talk­ing to any­one else.