Prepare for Roth Conversion Opportunity

Beginning next year, there’s a new opportunity for high income taxpayers. That’s when the current income limit for converting a traditional IRA to a Roth account will be eliminated. Here’s a rundown of the 2009 and 2010 rules, along with some steps you can take now to get ready for this tax-saving opportunity.

READY, SET, CONVERT

Taxpayers who convert a traditional IRA into a Roth IRA can enjoy a number of tax advantages, which are described in the right-hand box.

However, there’s always been a problem for higher-income folks. You can’t convert a traditional IRA into a Roth in a year when your modified adjusted gross income (MAGI) exceeds $100,000.

Good news: The $100,000 restriction will disappear at the end of this year. Starting in 2010, you can convert a traditional IRA into a Roth no matter how high your income (assuming Congress doesn’t change the law).

Bonus: For federal tax purposes, with a 2010 conversion, you can choose to spread the resulting taxable income evenly over 2011 and 2012 and thereby defer the related taxes.

While this is a great opportunity, 2010 is still weeks away. Nevertheless, there may be steps you can take now to get ready. We’ll explain, but let’s first cover some more background information.

Why Converting Might Make Sense Now

Is the value of your traditional IRA still lower than before last year’s stock market drop? Do you expect to pay higher federal income tax rates in future years than you pay now? If you answered “yes” to these questions, you’re a candidate for converting your traditional IRA into a Roth.

Converting will trigger a current income tax bill because you’re deemed to receive the converted amount in a taxable distribution from the traditional IRA. But if your traditional IRA balance is low (and possibly your overall income too), the conversion tax hit will be less.

The relatively low current tax cost for converting, combined with the chance to avoid higher future taxes on additional wealth that accumulates in your Roth account as the economy recovers, add up to the perfect storm for a conversion.

Roth Conversion Basics

If you have several traditional IRAs, you can convert some accounts and leave others alone. Similarly, you can convert only a proportion of the balances in one or more IRAs.

If you’ve made some nondeductible traditional IRA contributions over the years, and then convert some of your traditional IRA balances to Roth status, the deemed distribution that takes place when you convert will be partly taxable and partly tax-free. Your tax adviser can handle the calculations.

The extra taxable income triggered by a conversion is added to your salary, self-employment earnings, investment income, and so forth. So if you convert a large-balance IRA, it could bump you into a higher tax bracket and make you ineligible for some tax breaks, such as the child and education tax credits and passive loss deductions from investment real estate.

To avoid this, consider converting a large traditional IRA balance (or balances) in stages over at least two years. For instance, if your 2009 MAGI won’t exceed $100,000, you could convert half of your traditional IRA balances this year and the other half next year (regardless of your 2010 income). Or if your 2009 income is too high, you could spread Roth conversions over 2010 and 2011 when the MAGI restriction will be gone.

This multi-year approach can prevent the extra conversion income from pushing you into higher tax brackets and negating AGI-sensitive tax breaks. If a multi-year strategy sounds good, start this year (if possible) because the 2009 federal income tax rates are probably as good as they are going to get. That will probably still be true next year. But after 2010, all bets are off. Rates for higher-income individuals may go up, which could make the multi-year conversion strategy inadvisable. (Hopefully, you’ll know your 2011 tax situation by the end of next year and will have time to plan your Roth conversion moves accordingly.)

Important: Although the income restriction for converting is being lifted next year, the income limits for annual Roth IRA contributions will still be in place. For example, you can make contribution for 2009 of up to $5,000 ($6,000 if you are age 50 on December 31, 2009). But once your MAGI exceeds $166,000 for married couples filing jointly ($105,000 for singles), the amount you can contribute goes down or “phases out.” You are no longer eligible to contribute to a 2009 Roth if your MAGI exceeds $176,000 for married couples ($120,000 for singles). So in 2010, you might be able to convert a traditional IRA to a Roth if your income is $200,000 or more, but you won’t be able to make an annual contribution to one. (The income restrictions on 2010 contributions have not yet been announced but they will be close to the 2009 figures.)

Reverse Ill-Fated Conversions

Another great feature about Roth conversions is you can change your mind. You have until October 15 of the year following the conversion year to “recharacterize” the converted account back to traditional IRA status. This amounts to reversing the earlier conversion.

Example: You decide to convert two traditional IRAs into Roth accounts in 2010 when there is no income restriction. In 2011, the values of the converted accounts decrease due to poor investment performance. You would have to pay tax on value that later disappeared. Thankfully, you have until October 15, 2011 to recharacterize the converted accounts back to traditional IRAs. Afterwards, it’s as if the conversions never happened. So you won’t owe income tax on the 2010 conversions reversed in 2011.

Preparing for 2010

So what can a higher-income person do on the Roth conversion front between now and 2010?

You might be able to take steps to shift taxable income from this year into next year if that’s necessary to get your 2009 MAGI below $100,000. That way, you can use the multi-year strategy to convert some IRA balances into Roth accounts this year and some more next year when the income limit won’t apply.

Start collecting the cash you’ll need to pay your Roth conversion tax bill. In general, you don’t want to pay the tax with money taken out of the traditional IRA that you’re converting because that would mean less tax-free income accumulating in the Roth. Also, if you withdraw money from a traditional IRA before age 59 1/2 to pay the conversion tax bill, you’ll generally owe the 10 percent premature withdrawal penalty tax. Bottom line: The conversion tax hit should usually be paid only with “outside money” rather than traditional IRA withdrawals. (Again, with a 2010 conversion, you’ll have the option of spreading the resulting taxable income over two years and deferring the related federal taxes.)

Split up a large-balance traditional IRA that you intend to convert into several smaller traditional IRAs. That way, you can convert them into separate Roth accounts and follow different investment strategies for each. Then, if one of the new Roth accounts drops in value, you can avoid an inflated conversion tax bill by reversing the conversion for that account (as explained above) and leave the better-performing Roth accounts alone.

Conclusion: While a Roth conversion may be a good idea for you, there are several variables to consider. Consult with your tax adviser as soon as possible about your situation.

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ROTH IRA BENEFITS

Here are some advantages of converting a traditional IRA, including a SEP or SIMPLE IRA, into a Roth IRA.

Unlike withdrawals from traditional IRAs, qualifying Roth withdrawals are free of federal income taxes and usually state income taxes too. Generally, qualifying withdrawals involve those taken after you’ve had at least one Roth account open for more than five years and you reach age 59 1/2.

Roth account owners who reach age 70 1/2 don’t have to take the required minimum distributions that must be withdrawn from traditional IRAs. So you can leave a Roth balance untouched for as long as you live. This makes a Roth an ideal asset to leave to heirs if you don’t need the money yourself.

Now is an especially good time for Roth conversions because the account values of many traditional IRAs are still depressed.

WISDOM FOR TODAY’S ECONOMY

Money Market Guarantee Over

The federal Guarantee Program for Money Market Funds, which was put into place last year, expired on September 18, 2009.

“As the risk of catastrophic failure of the financial system has receded, the need for some of the emergency programs put in place during the most acute phase of the crisis has receded as well,” said Treasury Secretary Tim Geithner.

No losses were incurred under the program and the federal government earned $1.2 billion in “participation fees” from it. The program was implemented in September 2008 to stabilize markets after a large money market fund’s announcement that its net asset value had fallen below $1 per share (“broke the buck”) in the wake of the failure of Lehman Brothers.