Fri, August 21, 2009
Roth IRA Conversions and 2010 - Part 1
The coming change in Roth IRA conversion rules has been discussed (seemingly) endlessly in the financial planning community, especially lately. What follows is a short summary of how the conversion laws will change. In future posts, I'll write more about the considerations that should go into a Roth IRA conversion decision.
In order to keep this simple, I’ll only discuss situations in which all your IRA accounts contain deductible contributions. Later I’ll explain how things change if you have both deductible and nondeductible IRA contributions in your accounts.
Current Roth Conversion Rules
Presently, conversions of regular IRAs (and other retirement accounts) into Roth IRAs are only available to taxpayers with modified adjusted gross incomes (MAGIs) $100,000 or less. Married taxpayers filing separate returns are not presently permitted to convert traditional IRAs into Roth IRAs at all. SEP-IRA and SIMPLE IRA accounts may also be converted, but conversions from SIMPLE IRAs can only be done after the taxpayer has participated in a SIMPLE IRA for two years.
Since regular IRA contributions were deducted from your income when they were first contributed, when you do a Roth conversion you must pay taxes on the converted funds. For the purpose of calculating MAGI, the converted funds are ignored. In other words, a married couple filing jointly with an AGI (not counting the conversion) of $100K qualifies for a conversion under current law even though they’ll pay taxes on an AGI that includes $100K plus the IRA conversion amount.
What Changes in 2010
Starting in 2010, the MAGI restrictions for Roth conversions will disappear, and married-filing-separately taxpayers will be able to do Roth conversions also. There’s an further wrinkle in the changes that take effect in 2010: if you do a conversion in 2010, unless you specifically elect otherwise none of the income from your conversion will be included in your 2010 taxable income. Instead, half will be included in your 2011 taxable income and half in your 2012 income. In other words, for conversions done in 2010 only, the conversion tax liability is deferred and can be paid out in future years.
The “Logic” Behind the Rule Change
Obviously, this tax law change is configured to encourage high-income taxpayers to do Roth conversions in 2010. Only in 2010 will Roth conversions get the twin benefits of deferred taxation and spreading the tax liability over two subsequent years.
In fact, the change was justified through some clever Congressional mathematics done in 2006. As originally calculated, the 2010 conversion change was projected to cause a tax revenue influx of $9.2 billion between 2011 and 2013 as taxpayers pay the one-time cost of converting to Roths. But in future years, the taxes that would have been collected from future IRA distributions will be lost. By only projecting out to 2016, the original analysis made it possible to argue that this change would have the net effect of increasing tax revenues. In the long-term, it probably doesn’t
It’s possible that someone in Congress will point out that repealing the change before it takes effect would provide a long-term increase in tax revenues. In fact, BusinessWeek magazine speculated in 2006 that the 2010 conversion rule change would be repealed, but it hasn’t happened yet. If no changes are made before the end of this year, the strategies being hatched for 2010 Roth conversions will probably be safe; it would be politically tough for Congress to put a repeal into effect after 2010 starts.
What Else Is Set to Change in 2010
Coincidentally, the top four tax brackets are scheduled to revert to their pre-2001 levels in 2010. Today the top federal income tax brackets are 25%, 28%, 33%, and 35%. Assuming no future tax law changes (unlikely), those brackets are scheduled to return to 28%, 31%, 36%, and 39.6%. So the deferral of 2010 Roth conversion income will almost certainly result in higher total tax liabilities for some taxpayers. Anyone doing a conversion into a Roth IRA in 2010 will need to look carefully at the complete tax consequences, especially if they expect their income to increase in 2011/2012.
(Note: Doing a Roth conversion may or may not be a wise move for you; as always, you should consult a tax or financial advisor if you don’t have sufficient knowledge of the tax laws to determine accurately the financial impact of a rollover.)
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A Couple of Year-End Roth IRA Strategies
Further Note on Roth IRA Recharacterization/Conversion