• 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.

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