2010 is a unique year for retirement planning. It is the first year in which taxpayers are able to convert traditional, rollover, SEP and SIMPLE IRAs (as well as funds in most qualified retirement plans) to Roth IRAs regardless of their income or filing status. At Willingdon, we have had several inquiries from clients about whether taking advantage of this opportunity makes sense for them. I have read dozens of articles, spoken with a handful of CPAs, reviewed the IRS code and personally executed a number of conversions. While under the right circumstances this can be a very advantageous change, the decision is also unique to the specific situation of the person considering the conversion. While certain generalities are helpful, I recommend a consultation with us and/or your tax preparer before making a decision. If after reading this piece you want to talk more about whether a Roth conversion is the right strategy for you, please call or email me and we can set up a time to talk. Please note that action must be taken before the end of 2010 to take advantage of the one-time benefit of spreading the tax implications associated with Roth conversions over multiple years.
First, it is important to understand the difference between Roth IRAs and other types of IRAs and qualified plans. The earnings growth in all types of IRAs and qualified retirement plans, like 401(k)s, is almost always tax deferred. That means there are typically no capital gains taxes associated with selling an investment at a gain in retirement accounts. The tax implications are typically applicable only when a contribution or distribution is made. Non-Roth IRA and 401(k) contributions are often tax deductible, grow tax deferred, and are taxed as income when the account holder takes a distribution. Roth IRA contributions are made with after tax dollars, earnings grow tax deferred and distributions after 59 ½ years old are usually tax free.
One common misconception is that 2010 is the only year the opportunity to convert regardless of income exists. 
There is a unique component to this conversion option that is only available in 2010, but the income cap on conversions has been removed in future years as well. What makes 2010 special is that people who convert before the end of the calendar year have the option of reporting the income associated with the conversion entirely in 2010 or half in 2011 and half in 2012. One of those two options must be chosen and no other division of the income reporting is allowed. While the conversion must be done before the end of 2010, the decision on when to report the income does not have to be made until filing your 2010 tax return. Beginning in 2011, taxpayers must recognize all the income from a conversion in the year they make the conversion.
While I mentioned earlier that a few generalizations are not sufficient to determine whether a conversion makes sense for you, there are some consensus views that are helpful in determining whether to pursue a conversion:
- The ability to pay the taxes associated from the conversion from money outside of the IRA is very important.
- The longer the period of time from the conversion until you plan take a distribution from the Roth IRA, the more likely the conversion makes sense. In most cases I would not advise a conversion for people who plan to start taking regular distributions in less than 15 years.
- Conversions can make sense for people in lower tax brackets who intend to pass the IRA on to their children in higher tax brackets. Distributions from inherited Roth IRAs are typically not taxable, while distributions are usually taxed as ordinary income from other types of inherited IRAs and qualified plans.
- People that anticipate being in a higher tax bracket when they plan to take distributions from retirement accounts should also consider converting. (This is probably the most difficult to project because it involves speculating about future income as well as changes to tax brackets and other possible tax code changes.)
- Converting should be more strongly considered for people who do not currently have Roth IRAs. It may be helpful to have the flexibility of both types of IRAs when structuring distributions in retirement.
Other considerations:
- You don’t have to convert an entire IRA. Partial conversions of any amount are allowed.
- Typically, no sales of your existing investments are required. Investments in your current IRA can be transferred “in-kind” to a Roth IRA at no cost.
- If you plan to take advantage of the unique opportunity to spread the income of the conversion equally between 2011 and 2012, it may make sense to avoid the standard year-end tax planning of accelerating deductions and deferring income in 2010. (i.e. if you plan to make a tax deductible charitable contribution it may make sense to make the contribution in early 2011 instead of before the end of 2010).
- Be careful to avoid the conversion bumping you into a higher tax bracket if possible. This is where partial conversions and consultation/planning with your tax preparer could come in handy.
- People who are not able to make tax-deductible IRA contributions in 2010 should consider making non-deductible contributions and converting them. Taking advantage of that is an underutilized strategy that can be particularly beneficial if a Roth conversion makes sense.
- I am a CFP® (Certified Financial Planner), not a licensed tax advisor. It is important to note that some statements in this document may not be accurate as it relates to specific, individual tax situations. This document is not intended to provide specific tax advice. Please consult your tax preparer with questions related to the tax impact for you.
- My contact information is below if you want to discuss whether a Roth Conversion makes sense for you:
Brian S Jones, CFP®
704-659-7811
