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Articles: Roth IRA coversions: it’s decision time

With all the buzz about Roth IRA conversions in 2010, you may have taken the plunge. But now you want to “undo” the conversion. Is it possible? Yes. This technique is called the Roth IRA recharacterization.

The deadline for recharacterizing a Roth is your tax return due date plus extensions. So you effectively have until October 17, 2011, to recharacterize a 2010 conversion.

Background: When you convert a traditional IRA to a Roth IRA, you are taxed on the amount transferred.  But qualified distributions (e.g., distributions after age 59 1/2) from a Roth in existence at least five years are completely tax-free.

Plus, unlike a traditional IRA, you don’t have to take required distributions after age 70 1/2.

Prior to 2010, you could not convert a traditional IRA to a Roth in a year in which your modified adjusted gross income (MAGI) exceeded $100,000. But this rule no longer applies. Also, for a conversion occurring in 2010, you can split the taxable income evenly over 2011 and 2012.

However, if you converted to a Roth in 2010, you may find that paying the tax bill dilutes much of the tax benefit of the conversion.  Or maybe you didn’t count on state income tax liability.  Perhaps you did not consider the possibility of rising tax rates. Finally, if the value of the assets has declined since the conversion date, you could face a higher tax bill than you expected.

If it suits your needs, you can convert a recharacterized Roth back into a Roth before the later date of:

  • the beginning of the tax year following the tax year of the conversion
  • the end of the 30-day period beginning the day of the reconversion (regardless of whether the reconversion falls in the year of the conversion or the following year)

For example, if you converted a traditional IRA to a Roth on December 15, 2010, and recharacterized it on January 1, 2011, you cannot reconvert before January 14, 2011.

Finally, be aware that you don’t have to recharacterize the entire amount.  You can undo part of the conversion and keep the rest in the Roth.

The end of the year is rapidly approaching.  For many individuals contemplating a converision from a traditional IRA to a Roth, it’s time to make some critical decisions.

Let’s start with a brief comparison.  Distributions from a traditional IRA are generally taxed at ordinary income rates, currently reaching as high as 35%.  (Future tax rates are scheduled to rise.)

The taxable portion includes earnings within the tax-deferred account and amounts attributable to deductible contribuitons.

In contrast, “qualified distributions” from a Roth IRA are completely tax-free. A qualified distribution is one from a Roth in existence for at least five years that is made after you have reached age 59 1/2; upon death or disability; or to pay for first-time home-buyer expenses (up to a lifetime limit of $10,000).

Other distributions are treated as coming first from Roth IRA contributions, second from amounts transferred to the Roth, and third from earnings.

In effect, a conversion of assets from a traditional IRA to a Roth is treated as a withdrawal for tax purposes.  So you are generally required to pay the usual amount of tax when you convert.

But the current tax cost may be worth it in exchange for future tax-free distributions.  Furthermore, unlike a traditional IRA, you don’t have to take minimum distributions from a Roth after age 70 1/2.

What’s been holding some people back?  Prior to this year, a conversion was not allowed in a year in which your modified adjusted gross income (MAGI) exceeded $100,000.  However, beginning in 2010, this restriction has been removed.  Therefore, high-income individuals may be eligible to convert to a Roth for the first time.

Another incentive:  For a conversion in 2010 and 2010 only you can choose to have the taxable income from the conversion split evenly over the following two years: 2011 and 2012.

But there are potential drawbacks to a conversion.  For instance, if you have to use funds from your IRA to pay the resulting tax, it will likely dilute future benefits. Similarly, you might not choose the two-year tax deferral if you will be in a low tax bracket this year or anticipate being in higher tax brackets in the future. Other key factors to consider include:

  • Your age, your spouse’s age (if married) and the ages of the beneficiaries
  • The value of the assets in your IRA
  • The need to receive Roth IRA distributions in the future
  • The projected investment rate of return
  • Any state and local tax implications
  • Whether nondeductible amounts were contributed to the traditional IRAs and, if so, how much

These factors will have a substantial impact on your decision.   It requires a careful analysis of your situation.   Be wary of online calculators that leave out critical factors.

Finally, note that a conversion is not necessarily an all-or- nothing proposition.  If it suits your purposes, you might opt for a partial conversion.  In any event, obtain expert professional guidance.

This newsletter/advertisement is produced for our clients, friends and associates through an arrangement with WPI Communications, Inc. for the representatives’ use. Although the editorial content is professionally researched, written and edited, neither our firm nor any of its agents, representatives or associates make any representations regarding the accuracy of the content or its applicability to your situation. The information in this communication is not intended as tax or legal advice. In accordance with IRS Circular 230, the information provided herein may not be relied on for purposes of avoiding any federal tax penalties. Any tax advice contained in the body of this material was not intended or written to be used, and cannot be used, by the recipient for the purpose of 1) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions, or 2) promoting, marketing or recommending to another party any transaction or matter addressed herein. You are encouraged to seek tax or legal advice from an independent advisor.


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