by Dave Harlow, CPA/PFS

Why it’s worth looking into

With April 15 looming, there is still time to plan for what the 2010 tax year will bring. One important issue to consider is the change in IRA-to-Roth IRA Conversion rules.

What’s Changed

Before 2010, only individuals with modified adjusted gross incomes (AGI) of $100,000 or less could convert assets from their traditional IRA to a Roth IRA. Married taxpayers filing separate returns were prohibited from converting regardless of their AGI.

Beginning in 2010, the $100,000 AGI limit on conversions is eliminated. Income level no longer restricts conversion of a traditional IRA (and funds rolled over from a qualified plan) to a Roth IRA.

Filing status restrictions are also lifted, allowing married taxpayers filing separate or joint returns to convert a traditional IRA to a Roth IRA.

As a special incentive, tax on the income generated from a 2010 conversion can be (but does not have to be) deferred until 2011 and 2012.

Should You Convert?

There are a variety of reasons you may decide to convert your traditional IRAs to Roth IRAs, which have two major advantages over traditional IRAs:

  • Roth IRA distributions are tax-free if they are qualified distributions. To be qualified, they must be made after a 5-year holding period has passed and after the account holder reaches age 59 1/2.
  • Roth IRAs are not subject to the required minimum distribution (RMD) rules that apply to traditional IRAs. Therefore, a Roth IRA account-holder who reaches age 70 1/2 does not need to begin taking distributions; instead, the funds can continue to grow tax-free until they are needed or are passed to heirs.

The tax-free nature of Roth IRA distributions may help you avoid higher tax brackets that would otherwise apply if you were withdrawing distributions from a traditional IRA. Moreover, these distributions—unlike those from traditional IRAs—do not affect the calculation of tax owed on Social Security payments.

You should consider an IRA-to-Roth-IRA conversion if any of the following apply to you:

  • You can afford to pay the tax on the converted amounts from an account other than the IRA;
  • you expect to be in a higher tax bracket in the future or have certain favorable tax attributes that will lower your 2011-2012 taxable income; or
  • you have enough time before retirement to allow assets to grow tax-free and recoup dollars lost due to the taxes upon conversion; or
  • you have an estate tax problem that the conversion can possibly help alleviate.

How It Works

Before you start filling out the conversion paperwork, it’s important to assess a few essential details on how the conversion rules work and how they may impact you one way or the other.

First, an IRA conversion is treated as a taxable distribution. It’s taxed as ordinary income at your marginal tax rate (any early withdrawal penalty is waived in a conversion). This in effect accelerates the taxable income that you would eventually have had to pay on distributions from a traditional IRA when you retire. It does so in exchange for never taxing any future appreciation in the value of your account. This can be a significant tax advantage for some taxpayers, but it may or may not be an advantage for you.

Second, if you do choose to convert in 2010 and pay the taxes sooner rather than later, you face another decision on exactly how soon. Although conversion to a Roth IRA triggers immediate taxable income, Congress has provided a special incentive in 2010 to jump-start Roth conversions under the new rules: In 2010 (and 2010 only) you must elect one or the other of these two options:

  • You can recognize all the conversion income in 2010; or
  • you can average it over 2011 and 2012, spreading taxes on the converted amount over the rates in effect during those 2 years.

Third, even if you can chart out your own expected income during the coming 3 years, there are forces beyond our control that can create even greater challenges. The 2001 tax cuts are designed to sunset after 2010, bringing marginal tax rates back to 39.6% for taxpayers who earn more than $250,000 per year. If you do not want to take the chance that your income tax rates will be higher in 2011 to 2012 than in 2010, you may decide to elect to pay the full tax on the Roth conversion in 2010.

Clearly, deciding whether to convert from traditional to Roth requires some careful planning for tax years 2010 to 2012. This is especially so if your income is subject to fluctuation, as has been the case among many dental professionals during the recent economic turmoil. It also requires assessing the optimal way to report a conversion taken, and calculating proper payment of estimated taxes. And remember, the Roth conversion is not an all-or-nothing proposition. You may convert as little or as much of your traditional IRA as you want.

Applying It To You and Yours

If you are planning to take advantage of the Roth IRA conversion opportunity, consider some of the following.

Because of the economic slowdown, many individuals are postponing retirement. Roth IRAs, unlike traditional IRAs, generally have no age limitation on contributions from earned income or on mandatory payouts. This is an advantage if you are extending your career beyond the traditional retirement age.

If you can make deductible IRA contributions for 2009 before your tax return is due on April 15, I recommend you consider doing so. It can help reduce your 2009 tax bill. If you then convert the contributions to a Roth IRA in 2010, you will not have to pay back the tax savings until 2011 to 2012 (if you elect to ratably pay the tax over that 2-year period).

Additionally, you may want to consider making nondeductible IRA contributions for 2009 and 2010, since you can later roll over the amounts into Roth IRAs at no tax cost.

As described above, there are significant tax and financial considerations that come into play when determining whether to convert your traditional IRA to a Roth. There are also numerous techniques that can be used to maximize the benefits associated with the conversion, depending on the long-term objectives you have for your IRA and its assets. Following are some tips and traps:

Having retirement funds in a Roth IRA gives you additional tools for long-term, wealth-management levels of planning. For example, you will have one more choice when deciding which money to first draw in retirement: personal, already-taxed funds, retirement plan funds, or your Roth account.

When planning for your Roth IRA conversion, consider your tax and financial circumstances, but also think of your heirs. In other words, consider the estate and advanced planning implications of an IRA-to-Roth-IRA conversion. Income tax now may be much less than estate tax later.

Orthodontists with larger, diversified portfolios should consider rolling their IRAs into more than one Roth IRA. If you have different asset classes, consider separate Roth IRAs for each asset class. Tax law allows you to recharacterize or “undo” your conversion after the fact—by account. You can recharacterize as late as April 15, 2011, when you file your 2010 tax return, or October 15 if you file an extension. If you’ve cleverly established a separate account for each asset class, you can examine how each asset class has performed since it was converted, and undo particular asset classes, by account, that have declined in value. Why pay tax on an account you converted at $10,000 if it is only worth $8,000 by the date you are able to change your mind? Put it back in the traditional IRA and get the tax money back. You can then leave in place the accounts that have stayed the same or gone up in value, as you made a good choice. If asset classes are all mixed within one account, you cannot make these sorts of wise portfolio allocation choices.

And believe it or not, you can reconvert that recharacterized traditional IRA to a Roth IRA subject to some additional time constraints. How often do we get do-overs anymore?

If you put your 2010 tax return on extension until October 15, you still have to pay any tax created by the conversion by April 15, 2011, to avoid underpayment penalties. If your conversion remains in effect, your tax is all paid. If you recharacterize the Roth back to traditional, you can file your tax return accordingly and request a refund of the overpaid tax.

Unfortunately, you may not convert Inherited IRAs or Education IRAs to a Roth IRA.

Seek Professional Assistance

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Just as you might seek the advice or assistance of a specialist for a particularly complex treatment plan for a patient, the best advice on how to sort through the many possible benefits and considerations related to the new 2010 Roth Conversion rules is to contact a trusted adviser to discuss your personal situation. Some of this planning is straightforward, but as you drill down into each facet of how a Roth conversion can affect you in the long term, you are really looking at some very advanced planning.

Dave Harlow, CPA/PFS, is a partner at Capital Performance Advisors, LLP, Walnut Creek, Calif. He specializes in advising dental professionals on tax and financial planning matters. He can be reached at (925) 938-5188.